Financial Results

33 Management’s Discussion and Analysis 53 Consolidated Financial Statements 57 Notes to Consolidated Financial Statements 76 Report of Independent Registered Public Accounting Firm 77 Selected Financial Data 78 Board of Directors 79 Executive Officers and Senior Management 80 Corporate Information MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

GENERAL These companies form the core of our reportable segments. In 2004, we changed the reporting and responsibility relationships The following Management’s Discussion and Analysis of Results of our smaller business units so that they now report directly to a of Operations and Financial Condition (“MD&A”) describes the core segment. See Reportable Segments for further discussion. principal factors affecting the results of operations, liquidity, cap- ital resources and contractual cash obligations, as well as the The key factors that affect our operating results are as follows: critical accounting policies and estimates, of FedEx Corporation • the overall customer demand for our various services; (also referred to as “FedEx”). This discussion should be read in conjunction with the accompanying audited financial statements, • the volumes of transportation and business services provided which include additional information about our significant account- through our networks, primarily measured by our average daily ing policies, practices and the transactions that underlie our volume and shipment weight; financial results. • the mix of services purchased by our customers; Our MD&A is comprised of three major sections: Results of • the prices we obtain for our services, primarily measured by Operations, Financial Condition and Critical Accounting Policies average price per shipment (yield); and Estimates. Results of Operations begins with an overview of consolidated 2004 results compared to 2003, and of 2003 results • our ability to manage our cost structure for capital expenditures compared to 2002. This section includes a discussion of key and operating expenses such as salaries and benefits, fuel and actions, such as our business realignment initiatives and the maintenance; and acquisition of FedEx Kinko’s, as well as a discussion of our out- • our ability to match operating costs to shifting volume levels. look for 2005. The overview is followed by a financial summary and narrative (including a discussion of both historical operating Except as otherwise specified, references to years indicate our results and our outlook for 2005) for each of our four reportable fiscal year ended May 31, 2004 or ended May 31 of the year operating segments. We then provide an analysis of changes in referenced and comparisons are to the prior year. our balance sheet and cash flows and discuss our financial com- mitments in the Financial Condition section. We conclude with a discussion of the critical accounting policies and estimates that we believe are important to understanding the judgments and assumptions incorporated in our reported financial results. FedEx provides a broad portfolio of transportation, e-commerce and business services with companies that operate indepen- dently and compete collectively under the respected FedEx brand. These operating companies are primarily represented by FedEx Express, the world’s largest express transportation company; FedEx Ground, North America’s second largest provider of small- package ground delivery service; FedEx Freight, a leading U.S. provider of regional LTL freight services; and FedEx Kinko’s, a leading provider of document solutions and business services.

33 FEDEX CORPORATION

RESULTS OF OPERATIONS

CONSOLIDATED RESULTS The following table compares revenues, operating income, operating margin, net income and diluted earnings per share (dollars in mil- lions, except per share amounts) for the years ended May 31: $ Change Percent Change 2004 2003 2002 2004/2003 2003/2002 2004/2003 2003/2002 Revenues $24,710 $22,487 $20,607 2,223 1,880 10 9 Operating income 1,440 (1) 1,471 1,321 (31) 150 (2) 11 Operating margin 5.8% 6.5% 6.4% n/a n/a (70) bp 10 bp Net income $838(1)(2) $ 830 $ 710 (3) 8 120 1 17 Diluted earnings per share $ 2.76 (1)(2) $ 2.74 $ 2.34(3) 0.02 0.40 1 17

(1) Includes $435 million ($270 million, net of tax, or $0.89 per diluted share) of business realignment costs described below. See Note 4 to the accompanying audited financial statements. (2) Includes a $37 million, net of tax, or $0.12 per diluted share benefit related to a favorable ruling on a tax case and the reduction of our effective tax rate described below. See Note 11 to the accompanying audited financial statements. (3) Results for 2002 reflect our adoption of SFAS 142, “Goodwill and Other Intangible Assets.” We recognized an adjustment of $25 million ($15 million, net of tax, or $0.05 per diluted share) to reduce the carrying value of certain goodwill to its implied fair value. See Note 3 to the accompanying audited financial statements.

The following table shows changes in revenues and operating income by reportable segment for 2004 compared to 2003, and 2003 compared to 2002 (in millions): $ Change Percent Change $ Change Percent Change Revenues Revenues Operating Income Operating Income 2004/2003 2003/2002 2004/2003 2003/2002 2004/2003 2003/2002 2004/2003 2003/2002 FedEx Express segment 1,030 1,029 6 7 (154) (1) (18) (20) (2) FedEx Ground segment 329 663 9 23 28 157 6 47 FedEx Freight segment 246 190 10 8 51 8 26 4 FedEx Kinko’s segment 521 n/a n/a n/a 39 n/a n/a n/a Other and Eliminations (2) 97 (2) n/a n/a 5 3 n/a n/a 2,223 1,880 10 9 (31) 150 (2) 11

(1) Includes $428 million of business realignment costs described below. (2) Includes the results of operations of FedEx Kinko’s from February 12, 2004 (date of acquisition) through February 29, 2004 (approximately $100 million of revenue and $6 million of operating income).

Revenue growth during 2004 was attributable to increased vol- increased 11% as FedEx Ground significantly improved its oper- umes of FedEx Express International Priority (IP), FedEx Ground ating margin, which more than offset a decline in the operating and FedEx Freight shipments, as well as strong growth of IP margin at FedEx Express. The sluggish economy, combined with yields at FedEx Express. Yield improvements at FedEx Ground and significant increases in pension and healthcare costs and higher FedEx Freight also contributed to revenue growth. In addition, maintenance expenses, reduced profitability at FedEx Express in FedEx Kinko’s (acquired on February 12, 2004) added $621 million 2003 despite continued cost control efforts. of revenue during 2004. During 2003, revenue growth was due to Salaries and benefits expense increased 10% during 2004 due to the substantial growth of our FedEx Ground business, increased higher incentive compensation and pension costs, wage rate international volumes at FedEx Express and higher revenues at increases and the acquisition of FedEx Kinko’s. Incentive com- FedEx Freight. Increased U.S. freight volumes at FedEx Express pensation increased approximately $240 million during 2004 due also contributed to consolidated revenue growth in 2003, as we to above-plan operating income, primarily at FedEx Express and benefited from a full twelve months of revenue under the trans- FedEx Freight. Incentive compensation declined in 2003 based on portation agreement with the U.S. Postal Service (“USPS”), which below-plan performance at FedEx Express. Pension costs were commenced in late August 2001. approximately $115 million higher in 2004 (on top of an $80 million Operating income decreased 2% in 2004 as costs related to our increase in 2003), due principally to lower discount rates and business realignment initiatives totaled $435 million (partially off- decreased returns on pension plan assets. Although not legally set by approximately $150 million of savings). See “Business required, we made $320 million in contributions to our qualified Realignment Costs” for a discussion of these costs and related U.S. pension plans in 2004 compared to total contributions savings. In total, operating expenses, other than business realign- exceeding $1 billion in 2003. Our 2003 contributions were made to ment costs, increased less than the increase in revenue during ensure our qualified U.S. pension plan assets exceeded the related 2004, despite significant increases in incentive compensation, accumulated benefit obligations at our February 28, 2003 plan pension and maintenance costs. During 2003, operating income measurement date.

34 MANAGEMENT’S DISCUSSION AND ANALYSIS

Other Income and Expense and Income Taxes Costs were also incurred in 2004 for the elimination of certain Net interest expense decreased slightly in 2004 as the effects of management positions at FedEx Express and other business the tax case described below offset increases to interest units based on the staff reductions from the voluntary programs expense. These increases were due to the amendment of aircraft and other cost reduction initiatives. Costs for the benefits pro- operating leases and the adoption of Financial Accounting vided under the voluntary programs were recognized in the Standards Board Interpretation No. (“FIN”) 46, “Consolidation of period that eligible employees accepted the offer. Other costs Variable Interest Entities, an Interpretation of ARB No. 51,” which associated with business realignment activities were recognized together resulted in eight MD11 aircraft being recorded as fixed in the period incurred. assets and the related obligations being recorded as long-term We recognized $435 million of business realignment costs during debt. Interest expense also increased due to additional borrow- 2004. Savings of approximately $150 million were realized, reflected ings related to the FedEx Kinko’s acquisition. Net interest expense primarily in lower salaries and benefits costs. The components of was 15% lower in 2003 due to reduced borrowings. our business realignment costs and changes in the related accru- In August 2003, we received a favorable ruling from the U.S. als were as follows for the year ended May 31, 2004 (in millions):

District Court in Memphis over the tax treatment of jet engine Voluntary Voluntary maintenance costs. The Court held that these costs were ordinary Retirement Severance Other (1) Total and necessary business expenses and properly deductible. As a Beginning accrual balances $– $– $– $– result of this decision, we recognized a one-time benefit in 2004 Charged to expense 202 158 75 435 of $26 million, net of tax, or $0.08 per diluted share, primarily Cash paid (8) (152) (31) (191) related to the reduction of accruals related to this matter and the Amounts charged to other recognition of interest earned on amounts previously paid to the assets/liabilities (194) – (22) (216) IRS. Future periods are not expected to be materially affected by Ending accrual balances $– $6 $22$28 the resolution of this matter. Although the IRS has appealed this (1) Other includes costs for management severance agreements, which are payable over ruling, we believe the District Court’s ruling will be upheld (also, future periods, including compensation related to the modification of previously granted see Note 11 to the accompanying audited financial statements). stock options and incremental pension and healthcare benefits. Other also includes profes- sional fees directly associated with the business realignment initiatives and relocation costs. Our effective tax rate was 36.5% in 2004, 38.0% in 2003 and 37.5% in 2002. The lower effective rate in 2004 was primarily attributable Total cash payments under these programs are expected to be to the favorable decision in the tax case discussed above, approximately $220 million. Amounts charged to other assets/ stronger than anticipated international results and the results of liabilities relate primarily to incremental pension and health- tax audits during 2004. Our stronger than anticipated international care benefits. results, along with other factors, increased our ability to credit Over the past few years, we have taken many steps toward bring- income taxes paid to foreign governments on foreign income ing our expense growth in line with revenue growth, particularly against U.S. income taxes paid on the same income, thereby at FedEx Express, while maintaining our industry-leading service mitigating our exposure to double taxation. The 38.0% effective levels. We have significantly decreased capital expenditures by tax rate in 2003 was higher than the 2002 rate primarily due to reducing aircraft orders, consolidating facilities and discontinu- lower state taxes in 2002. The effective tax rate exceeds the ing low-value programs. These business realignment initiatives statutory U.S. federal tax rate primarily because of state income are another step in this ongoing process of reducing our cost taxes. For 2005, we expect the effective tax rate to be approxi- structure in order to increase our competitiveness, meet the mately 38.0%. The actual rate, however, will depend on a number future needs of our employees and provide the expected finan- of factors, including the amount and source of operating income. cial returns for our shareholders. Business Realignment Costs FedEx Kinko’s Acquisition During 2004, voluntary early retirement incentives with enhanced On February 12, 2004, we acquired FedEx Kinko’s for approxi- pension and postretirement healthcare benefits were offered to mately $2.4 billion in cash. We also assumed $39 million of capital certain groups of employees at FedEx Express who were age 50 lease obligations. FedEx Kinko’s is a leading provider of docu- or older. Voluntary cash severance incentives were also offered ment solutions and business services. Its network of worldwide to eligible employees at FedEx Express. These programs, which locations offers access to color printing, finishing and presenta- commenced August 1, 2003 and expired during the second quar- tion services, Internet access, videoconferencing, outsourcing, ter, were limited to eligible U.S. salaried staff employees and managed services, Web-based printing and document manage- managers. Approximately 3,600 employees accepted offers ment solutions. under these programs. The response to these voluntary pro- grams substantially exceeded our expectations. Consequently, The transaction was accounted for as a purchase. Accordingly, replacement management and staff were required and some the assets and liabilities of FedEx Kinko’s were recorded at their employee departure dates were deferred (up to May 31, 2004). fair values and the excess of the purchase price over the fair

35 FEDEX CORPORATION

value of assets acquired was recorded as goodwill. A signifi- Airline Stabilization Compensation cant amount of the purchase price was recorded as goodwill, Operations in 2002 were significantly affected by the terrorist as the acquisition of FedEx Kinko’s expands our portfolio of attacks on September 11, 2001. During 2002, we recognized a total business services, while providing a substantially enhanced of $119 million of compensation under the Air Transportation capability to provide package-shipping services to small- and Safety and System Stabilization Act (the “Act”), of which $101 medium-sized business customers through FedEx Kinko’s array million had been received as of May 31, 2004. The amounts rec- of retail store locations. ognized were for our estimate of losses we incurred as a result of the mandatory grounding of our aircraft and for incremental losses The assets and liabilities related to FedEx Kinko’s have been incurred through December 31, 2001. All amounts recognized included in the accompanying audited balance sheet based on a were reflected as reduction of operating expense under the purchase price allocation. The allocation of the purchase price caption “Airline stabilization compensation.” to the fair value of the assets acquired, liabilities assumed and goodwill, as well as the assignment of goodwill to our reportable In the fourth quarter of 2003, the Department of Transportation segments, was based primarily on internal estimates of cash (“DOT”) asserted that we were overpaid by $31.6 million and has flows and independent appraisals. We used an independent demanded repayment. We have filed requests for administrative appraisal firm to determine the fair value of certain assets and and judicial review. We received an opinion from the District of liabilities, primarily property and equipment and acquired intan- Columbia U.S. Court of Appeals stating that most of the determi- gible assets, including the Kinko’s trade name, customer-related nations that we requested were not yet ripe for decision and the intangibles, technology assets and contract-based intangibles. Court will not rule prior to final determination by the DOT and While the purchase price allocation is substantially complete and exhaustion of administrative remedies. we do not expect any material adjustments, we may make adjust- Pursuant to the Federal Aviation Administration reauthorization ments to the purchase price allocation if new data becomes enacted during the third quarter of 2004, the General Accounting available. See Notes 2 and 3 to the accompanying audited finan- Office submitted a report to Congress on June 4, 2004, on the cri- cial statements for further discussion of the purchase price teria and procedures used by the Secretary of Transportation allocation and goodwill and intangible assets. under the Act. Issuance of the report frees the DOT to make The results of operations of FedEx Kinko’s have been included in a final determination on our claim and also reinforces the our consolidated financial statements from February 12, 2004. Congressional directive to the DOT to refer any remaining dis- During 2004, FedEx Kinko’s contributed $621 million of revenue puted claims to an administrative law judge upon an affected and $0.06 per diluted share of earnings, which includes approxi- claimant’s request. mately $15 million of interest and financing costs and $3 million We agreed to mediation with the DOT, but it did not result in a of rebranding costs. Note 2 to the accompanying audited finan- resolution of the dispute. We will continue to pursue our claim cial statements includes the unaudited pro forma results of for compensation under the Act. operations of FedEx as if the acquisition had occurred as of the beginning of 2003. The accounting literature establishes We believe that we have complied with all aspects of the Act, firm guidelines around how this pro forma information is pre- that it is probable we will ultimately collect the remaining $18 mil- sented, which precludes the assumption of business synergies. lion receivable and that we will not be required to pay any portion Therefore, this unaudited pro forma information is not intended of the DOT’s $31.6 million demand. We cannot be assured of the to represent, nor do we believe it is indicative of the consolidated ultimate outcome; however, it is reasonably possible that a results of operations of FedEx that would have been reported had material reduction to the $119 million of compensation we have the acquisition been completed as of the beginning of 2003. previously recognized under the Act could occur. Based on the Furthermore, this pro forma information is not representative of DOT’s assertion, the range for potential loss on this matter is zero the future consolidated results of operations of FedEx. to $49.6 million. We paid a portion of the purchase price from available cash Outlook balances. To finance the remainder of the purchase price, we During 2005 (particularly during the first half), we expect the U.S. entered into a six-month credit facility for $2 billion. During economy to sustain the growth evident in the second half of 2004. February 2004, we issued commercial paper backed by unused This growth is supported by strong corporate earnings, higher commitments under this facility. In March 2004, we replaced the consumer confidence (led by both increasing income and an commercial paper with the issuance of $1.6 billion of senior improving job market) and public sector improvement. The macro unsecured notes in three maturity tranches: one, three and five economic environment during 2004 was particularly challenging years at $600 million, $500 million and $500 million, respectively. for our business, as the manufacturing and wholesale sectors We canceled the six-month credit facility in March 2004. See of the economy lagged behind gross domestic product, and Notes 2 and 6 of the accompanying audited financial statements year-over-year performance in the economy lagged sequential for further discussion. quarter-to-quarter growth. We expect the current economic

36 MANAGEMENT’S DISCUSSION AND ANALYSIS

expansion to broaden into the manufacturing and wholesale sec- The pilots of FedEx Express, which represent a small number of tors during 2005 as supported by the recent strengthening of FedEx Express total employees, are employed under a collective durable goods sales, indicating the inventory restocking cycle has bargaining agreement. Negotiations with the pilots’ union began in started. This is further supported by the positive year-over-year March 2004, as the current agreement became amendable on May volume trends across all our transportation companies in the 31, 2004. We will continue to operate under our current agreement fourth quarter of 2004. We also expect a strong global economy in while we negotiate with our pilots. Our financial results for 2005 2005, evidenced by recent broad-based growth across multiple may be affected by the results of these negotiations. However, we sectors and regions, particularly in Asia. cannot estimate the financial impact, if any, the results of these negotiations may have on our results of operations. Our outlook anticipates revenue and earnings growth in all our reportable segments for 2005, as we continue to leverage our Increased security requirements for air cargo carriers have been “compete collectively” philosophy. Our optimism stems from put in place and have not had a material impact on our operating increasing customer demand for services across our operating results for the periods presented. Although no specific proposals companies, a lower cost structure at FedEx Express, as well as have been issued, further measures may be forthcoming. The improving worldwide economic conditions. During 2005, we impact on our results of operations of any such additional mea- expect continued strong growth of international volumes and sures is unknown. yields at FedEx Express. We expect only slight U.S. domestic vol- Future results will depend upon a number of factors, including ume growth at FedEx Express, with higher U.S. domestic yields to U.S. and international economic conditions, the impact from any account for a large portion of revenue growth at FedEx Express. terrorist activities or international conflicts, our ability to match We anticipate improved volumes and yields at FedEx Ground and our cost structure and capacity with shifting volume levels, our FedEx Freight, as FedEx Ground continues its multi-year capacity ability to effectively leverage our new service and growth initia- expansion plan and FedEx Freight continues to grow its regional tives and our ability to effectively operate, integrate and leverage and interregional business and enhance its portfolio of services. the FedEx Kinko’s business. In addition, adjustments to our fuel FedEx Kinko’s revenue is projected to be approximately $2.1 billion, surcharges at FedEx Express lag changes in actual jet fuel which is significantly higher than the partial year revenue included prices paid. Therefore, our operating income could be materially in our 2004 results. FedEx Kinko’s will focus on continuing to gen- affected should the spot price of jet fuel suddenly change by a erate revenue growth by aggressively growing current lines of significant amount or should we be unable to further increase our business and by leveraging its new relationship with FedEx. fuel surcharges in response to rising fuel prices due to competi- We anticipate significant year-over-year growth of both operating tive pressures. See “Forward-Looking Statements” for a more income and margins. These measures will be positively impacted complete discussion of potential risks and uncertainties that by revenue growth and the full-year savings from our business could materially affect our future performance. realignment initiatives (which are expected to be approximately Seasonality of Business $80 million to $90 million higher than 2004 savings) discussed Our express package and freight businesses are seasonal in above. Over the past several years we have experienced signifi- nature. Historically, the U.S. express package business experi- cant year-over-year increases in pension cost. For 2005, we expect ences an increase in volumes in late November and December. a modest $30 million increase in pension cost, as 2004 actual asset International business, particularly in the Asia to U.S. market, returns have substantially improved the funded status of our pen- peaks in October and November due to U.S. holiday sales. Our sion plans in spite of a continued decline in the discount rate. first and third fiscal quarters, because they are summer vacation Also, incentive compensation programs were reinstated to more and post winter-holiday seasons, have historically exhibited normalized levels in 2004, after several years of declines. Our man- lower volumes relative to other periods. agement teams continue to examine additional cost reduction and operational productivity opportunities as we focus on optimizing The transportation and business services industries are affected our networks, improving our service offerings, enhancing the cus- directly by the state of the overall domestic and international tomer experience and positioning FedEx to increase cash flow and economies. Seasonal fluctuations affect volumes, revenues and financial returns by improving our operating margin. earnings. Normally, the fall of each year is the busiest shipping period for FedEx Ground, while late December, January, June and During 2005, we expect to incur approximately $20 million of July of each year are the slowest periods. For FedEx Freight, the expenses related to the FedEx Kinko’s rebranding. In addition, we spring and fall of each year are the busiest periods and the latter plan to open approximately 70 new FedEx Kinko’s locations, part of December, January and February of each year are the including many internationally. Despite these costs, we expect slowest periods. Shipment levels, operating costs and earnings FedEx Kinko’s to contribute to earnings growth in 2005 as we for each of our transportation companies can also be adversely move quickly to expand our service offerings at its U.S. locations. affected by inclement weather. See “FedEx Kinko’s Acquisition” and “Reportable Segments” for additional discussion.

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NEW ACCOUNTING PRONOUNCEMENTS FEDEX EXPRESS SEGMENT No new accounting pronouncements had a material effect on our The following table compares revenues, operating expenses and financial position, results of operations or cash flows during 2004. operating income and margin (dollars in millions) and selected statistics (in thousands, except yield amounts) for the years REPORTABLE SEGMENTS ended May 31: FedEx Express, FedEx Ground, FedEx Freight and FedEx Kinko’s Percent Change 2004/ 2003/ form the core of our reportable segments. In 2004, we changed 2004 2003 2002 2003 2002 the reporting and responsibility relationships of our smaller Revenues: business units so they now report directly to a core segment. Package: Prior year amounts have been reclassified to conform to the U.S. overnight box $ 5,558 $ 5,432 $ 5,338 2 2 new segment presentation. Our reportable segments include the U.S. overnight following businesses: envelope 1,700 1,715 1,755 (1) (2) FedEx Express Segment FedEx Express (express transportation) U.S. deferred 2,592 2,510 2,383 3 5 FedEx Trade Networks Total U.S. domestic (global trade services) package revenue 9,850 9,657 9,476 2 2 International FedEx Ground Segment FedEx Ground (small-package Priority (IP) 5,131 4,367 3,834 17 14 ground delivery) Total package FedEx Supply Chain Services revenue 14,981 14,024 13,310 7 5 (contract logistics) Freight: U.S. 1,609 1,564 1,273 3 23 FedEx Freight Segment FedEx Freight (regional LTL freight) International 393 400 384 (2) 4 FedEx Custom Critical Total freight (surface-expedited transportation) revenue 2,002 1,964 1,657 2 19 Caribbean Transportation Services Other (1) 514 479 471 7 2 (airfreight forwarding) Total revenues 17,497 16,467 15,438 6 7

FedEx Kinko’s Segment FedEx Kinko’s (document solutions Operating expenses: and business services) Salaries and employee benefits 7,403 7,001 6,565 6 7 FedEx Services provides customer-facing sales, marketing and Purchased information technology support, primarily for FedEx Express and transportation 694 609 564 14 8 FedEx Ground. The costs for these activities are allocated based Rentals and on metrics such as relative revenues and estimated services pro- landing fees 1,531 1,557 1,531 (2) 2 vided. These allocations materially approximate the cost of Depreciation and providing these functions. The line item “Intercompany charges” amortization 810 818 819 (1) – on the accompanying financial summaries of our reportable seg- Fuel 1,343 1,231 1,009 9 22 ments includes the allocations from FedEx Services to FedEx Maintenance Express, FedEx Ground and FedEx Freight, allocations for services and repairs 1,193 1,087 983 10 11 provided between operating companies, and certain other costs Airline stabilization such as corporate management fees related to services received compensation ––(119) n/a n/a for general corporate oversight, including executive officers and Business realignment certain legal and finance functions. Management evaluates seg- costs 428 – – n/a n/a ment financial performance based on operating income. Intercompany charges 1,442 1,328 1,331 9 – Other 2,024 2,053 1,954 (1) 5 Total operating expenses 16,868 15,684 14,637 8 7 Operating income $ 629 $ 783 $ 801 (20) (2) Operating margin 3.6% 4.8% 5.2%

38 MANAGEMENT’S DISCUSSION AND ANALYSIS

Percent Change surcharge increases, became effective January 5, 2004. Freight 2004/ 2003/ 2004 2003 2002 2003 2002 revenue increased in 2004 due to increased yields related to ser- vice mix, despite lower volumes. Package Statistics (2) Average daily package volume (ADV): FedEx Express segment total revenues increased 7% in 2003, U.S. overnight box 1,179 1,176 1,170 – 1 largely due to increased IP and U.S. freight revenues. Year-over- U.S. overnight year revenue comparisons reflect the impact in 2002 of the envelope 667 679 699 (2) (3) terrorist attacks on September 11, 2001, which adversely affected U.S. deferred 925 897 868 3 3 both U.S. outbound international shipments and U.S. domestic Total U.S. shipments, and the economic decline that began in calendar 2001. domestic ADV 2,771 2,752 2,737 1 1 IP volume growth occurred predominantly in Asia and Europe, IP 396 369 340 7 9 which experienced average daily volume growth rates of 21% and Total ADV 3,167 3,121 3,077 1 1 11%, respectively, during 2003. IP yield improvements during 2003 Revenue per package (yield): were due to favorable exchange rate differences, increased fuel U.S. overnight box $ 18.49 $ 18.18 $17.90 2 2 surcharge revenue and growth in higher-yielding lanes. U.S. overnight U.S. domestic package revenue increased 2% in 2003 due to envelope 10.00 9.95 9.84 1 1 higher yield and volumes in the U.S. deferred and overnight box U.S. deferred 10.99 11.02 10.77 – 2 categories. The increase in U.S. domestic package yield during U.S. domestic 2003 was due to higher fuel surcharge revenue and average list composite 13.94 13.82 13.58 1 2 price increases. Higher U.S. freight revenues from increased IP 50.75 46.59 44.16 9 6 average daily pounds during 2003 also affected year-over-year Composite revenue comparisons, as we benefited from a full twelve months package yield 18.55 17.69 16.96 5 4 of operations and higher shipping levels under our transportation contract with the USPS, which began in August 2001. Freight Statistics (2) Average daily freight pounds: Fuel surcharge revenue was higher in 2004 and 2003 primarily U.S. 8,519 8,969 7,736 (5) 16 due to higher jet fuel prices and the introduction of certain International 2,093 2,174 2,082 (4) 4 international dynamic fuel surcharges in September 2002. Our Total average daily dynamic fuel surcharges are based on the spot price for jet fuel. freight pounds 10,612 11,143 9,818 (5) 13 During 2003, fuel surcharge revenue was also higher because our Revenue per pound (yield): dynamic index for determining our U.S. domestic fuel surcharge U.S. $ 0.74 $ 0.69 $ 0.65 7 6 was not implemented until the second quarter of 2002. Using this International 0.74 0.72 0.72 3 – index, the U.S. domestic fuel surcharge ranged between 3.0% Composite and 6.5% during 2004, 2.0% and 5.5% during 2003 and between freight yield 0.74 0.69 0.66 7 5 0% and 3% from November 2001 through May 2002. International (1) Other includes FedEx Trade Networks. fuel surcharges ranged between 2% and 6.5% during 2004 and (2) Package and freight statistics include only the operations of FedEx Express. were as high as 6% during 2003.

FedEx Express Segment Revenues FedEx Express Segment Operating Income FedEx Express segment total revenues increased 6% in 2004, During 2004, operating income decreased 20% due to business principally due to higher IP revenues in Asia, Europe and U.S. out- realignment costs totaling $428 million (partially offset by approx- bound. IP revenues increased significantly on volume growth imately $150 million of savings). Higher incentive compensation (7%) and higher yield (9%). Asia experienced strong average daily and pension costs and base salary increases, as well as higher volume growth (led by China with volume growth of over 50%), maintenance expenses, were offset by revenue growth and ongo- while outbound shipments from Europe, the United States and ing cost control efforts. In addition, 2004 benefited from one Latin America continued to improve. The increase in IP yield was additional operating day. During 2003, the 2% decrease in operat- largely attributable to Europe. The yield increase was primarily ing income and the decline in operating margin at FedEx Express due to higher average weight per package, favorable exchange were attributable to increased employee benefits costs, higher rate differences and higher fuel surcharge revenue. maintenance expenses and, to a lesser extent, the net impact of higher fuel costs in an economic environment of sluggish U.S. U.S. domestic package revenue increased 2% in 2004 as both vol- domestic average daily package volumes. Contributing to the umes and yields grew slightly. For U.S. domestic composite yield, decrease in operating income was one fewer operating day. a small decline in average rate per pound was offset by increases Operating results during 2003 were also impacted by unusually in average weight per package and fuel surcharge revenue. For inclement weather during the winter and spring, which decreased U.S. domestic shipments and U.S. outbound international ship- business shipping, reduced operational efficiency and increased ments, an average list price increase of 2.5%, along with certain certain operating costs, such as for snow removal and de-icing.

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Salaries and benefits were higher during 2004 due to higher incen- FedEx Express Segment Outlook tive compensation and pension costs and wage rate increases. We anticipate revenue growth at FedEx Express during 2005, in This increase was partially offset by savings from the business both the domestic and international markets. Revenue increases realignment initiatives. The 2003 increase was due to wage rate will be led by IP, where we expect volume and yield growth, par- increases and higher pension and healthcare costs. In addition, ticularly in Asia, U.S. outbound and Europe. We expect only slight higher salaries and benefits were partially the result of cost U.S. domestic volume growth at FedEx Express, with higher U.S. increases related to the USPS contract. Incentive compensation domestic yields to account for a large portion of revenue growth provisions declined in 2003 based on below-plan performance. at FedEx Express. Purchased transportation costs increased in 2004 and 2003 as IP We expect significant operating margin improvement at FedEx volume growth led to an increase in contract pickup and delivery Express during 2005, led by the full-year salaries and benefits services. Higher maintenance costs in both 2004 and 2003 were savings of our 2004 business realignment initiatives. These cost primarily due to the timing of scheduled aircraft maintenance management actions and improved volumes, along with a sharp events, higher utilization of aircraft related to USPS volumes focus on productivity, are expected to produce improved opera- and a higher average age of certain types of our aircraft. tional efficiency. In addition, we expect additional improvement Intercompany charges increased during 2004 due to higher due to IP volume growth with solid incremental margins, incentive compensation, healthcare and pension costs and base increased U.S. domestic yields and volumes aided by the FedEx salary increases at FedEx Services. Kinko’s retail presence and the impact of reduced capital spend- ing in prior years. While capital expenditures at FedEx Express Fuel costs were higher in 2004 due to a 10% increase in the aver- are expected to be higher than 2004 due to planned aircraft pur- age price per gallon of aircraft fuel, as fuel consumption was flat. chases to support IP volume growth, they are expected to remain However, fuel surcharge revenue more than offset higher jet fuel below historical levels. prices primarily due to the introduction of certain international dynamic fuel surcharges in September 2002. Fuel consumption FEDEX GROUND SEGMENT was higher in 2003, primarily due to an increase in aircraft usage The following table compares revenues, operating expenses and as a result of incremental U.S. freight pounds transported under operating income and margin (dollars in millions) and selected the USPS agreement and IP volume growth. Fuel costs were also package statistics (in thousands, except yield amounts) for the higher in 2003 due to a 16% increase in the average price per years ended May 31: gallon of aircraft fuel. Higher net fuel costs at FedEx Express Percent Change negatively affected operating income during 2003, as fuel sur- 2004/ 2003/ 2003 2002 2002 charge revenue increases were not sufficient to offset higher 2004 2003 jet fuel prices. Revenues $ 3,910 $ 3,581 $ 2,918 9 23 Operating expenses: Rentals and landing fees decreased in 2004 due to the amend- Salaries and ment of operating leases for six MD11 aircraft that resulted in employee benefits 740 709 623 4 14 these aircraft being recorded as fixed assets under capital lease. Purchased transportation 1,465 1,327 1,067 10 24 In addition, as discussed in Note 16 to the accompanying audited Rentals 98 88 85 11 4 financial statements, two additional MD11s were recorded as Depreciation and fixed assets at September 1, 2003 as a result of the adoption of amortization 154 155 136 (1) 14 FIN 46. Depreciation and amortization expense declined slightly Fuel 16 11 5 45 120 due to decreases in capital spending, despite the additional Maintenance and repairs 95 89 76 7 17 depreciation from the eight MD11 aircraft added to fixed assets. Business realignment During 2003, other operating expenses increased at FedEx costs 1 ––n/a n/a Express as reimbursements in 2002 from the USPS for network Intercompany charges 432 346 256 25 35 expansion costs were reflected as credits in other operating Other 387 362 333 7 9 expenses. These reimbursements, however, had no effect on Total operating operating income, as they represented the recovery of incre- expenses 3,388 3,087 2,581 10 20 mental costs incurred. Partially offsetting operating costs during Operating income $ 522 $ 494 $ 337 6 47 2003 was a gain from the insurance settlement on an aircraft Operating margin 13.4% 13.8% 11.5% destroyed in an accident in July 2002 that resulted in a net $8 Average daily (1) million favorable impact on operating income. During 2002, other package volume 2,285 2,168 1,755 5 24 operating expenses included $27 million from the favorable Revenue per package (1) resolution of certain state tax matters. (yield) $ 6.48 $ 6.25 $ 6.11 4 2 (1) Package statistics include only the operations of FedEx Ground.

40 MANAGEMENT’S DISCUSSION AND ANALYSIS

FedEx Ground Segment Revenues Operating margins improved in 2003 as FedEx Ground realized Revenues increased during 2004 due to higher volumes and yield substantial improvements in pickup and delivery and linehaul improvement, led by increased usage of our home delivery ser- productivity. Similar to 2004, intercompany charges increased due vice. Average daily volume continued its sequential growth in the to the utilization of a larger portion of allocated resources from fourth quarter, with a 12% increase over the fourth quarter of 2003, FedEx Services. Salaries and employee benefits increased in 2003 up from 1%, 3% and 6% growth in the first, second and third quar- due to higher pension costs and increases in staffing to support ters, respectively. The lower average daily volume increase for volume growth. Operating results during 2003 were also impacted 2004 was due to a difficult year-over-year comparison, as first by inclement weather during the winter and spring, which was quarter 2003 volume included an estimated 140,000 to 150,000 daily more severe than in previous years. packages as a result of the threat of a UPS work stoppage. In addi- The increase in operating income in both 2004 and 2003 was tion, 2004 benefited from two additional operating days. The FedEx also attributable to improved home delivery service results. In Ground segment realized 23% revenue growth in 2003, despite one September 2002, FedEx Ground completed the build-out of its less operating day, due to increased volumes in our business-to- national home delivery network, enabling it to reach nearly 100% business shipments and continued growth of our home delivery of U.S. residences, with evening, weekend and day- and time- service. During 2003, our home delivery service added facilities to specific delivery options, all backed by a money-back guarantee. reach nearly 100% coverage of the U.S. population. Our home delivery service became profitable during 2003. This Yield at FedEx Ground increased in 2004 primarily due to general service had an operating loss of $32 million during 2002. rate increases and an increase in extra services revenue, par- FedEx Ground Segment Outlook tially offset by higher customer discounts and the elimination of We expect FedEx Ground to return to double-digit revenue growth the fuel surcharge in January. An average list price increase of in 2005, led by increased home delivery and next-business day 1.9% on FedEx Ground services became effective January 5, package volume and modest yield improvement. Average daily 2004. On that date, the fuel surcharge for all FedEx Ground ship- volume is expected to improve on its 2004 growth of 5%. ments was discontinued. In 2003, year-over-year yield increases Anticipated yield improvements from the average list price were due to an average list price increase of 3.9%, which increase and extra services revenue will be partially offset by the became effective January 6, 2003. Partially offsetting the effect impact from the elimination of FedEx Ground’s fuel surcharge in of the price increase were higher levels of discounts and lower January 2004. FedEx Ground will also continue to place emphasis average weight per package. on improving on-time delivery, productivity and safety. In the third quarter of 2002, FedEx Ground implemented a dynamic During 2005, we expect continued growth in capital spending at fuel surcharge, based on the spot price for on-highway diesel fuel. FedEx Ground as we continue to focus on network capacity Before its elimination in January 2004, this surcharge ranged expansion. As a result of losses at FedEx Supply Chain Services, between 1.25% and 1.50% during 2004, between 0.75% and 2.00% higher facility expenses due to expansion and slower yield growth during 2003 and between 0.50% and 0.75% from February through primarily due to the elimination of FedEx Ground’s fuel surcharge, May 2002. we expect the 2005 operating margin will be comparable to 2004. FedEx Ground Segment Operating Income Operating income increased in 2004 due to volume growth, yield improvements and increased productivity. These gains were partially offset by higher intercompany charges, increased healthcare and pension costs and expenses related to terminal expansions and relocations. FedEx Ground utilized a larger por- tion of allocated sales, marketing, information technology and customer support resources. The cost of providing these services increased due to higher incentive compensation, healthcare and pension costs and base salary increases at FedEx Services. Operating margin for the segment was also negatively affected by operating losses at FedEx Supply Chain Services.

41 FEDEX CORPORATION

FEDEX FREIGHT SEGMENT due to the growth of our interregional freight service. During 2003, The following table shows revenues, operating expenses and operating income also increased due to LTL revenue growth and operating income and margin (dollars in millions) and selected cost management. Lower depreciation and amortization during statistics for the years ended May 31: 2003 reflects increased gains from the sale of operating assets in Percent Change the ordinary course of business. 2004/ 2003/ 2004 2003 2002 2003 2002 Operating margin improved more than 100 basis points in 2004 Revenues $2,689 $2,443 $2,253 10 8 on strong revenue growth. Lower operating margins in 2003 Operating expenses: reflect higher maintenance and repairs expenses, which include Salaries and $8 million of incremental expenses associated with rebranding employee benefits 1,427 1,303 1,218 10 7 our two regional LTL carriers under the common name “FedEx Purchased transportation 254 224 197 13 14 Freight.” The rebranding project began in the fourth quarter of Rentals and landing fees 100 105 101 (5) 4 2002 and is expected to be complete in 2005. Through the end of Depreciation and 2004, rebranding expenses totaled $31 million of the anticipated amortization 92 88 91 5 (3) total project cost of $41 million. These costs, which are being Fuel 122 107 87 14 23 expensed as incurred, consist primarily of incremental external Maintenance costs for rebranding tractors and trailers. and repairs 116 115 91 1 26 Intercompany charges 21 17 13 24 31 FedEx Freight Segment Outlook Other 313 291 270 8 8 We expect revenue to continue to grow in 2005, due to both LTL Total operating yield improvement and LTL daily shipment growth. Continued expenses 2,445 2,250 2,068 9 9 market share growth, a general rate increase and a relatively sta- Operating income $ 244 $ 193 $ 185 26 4 ble industry-pricing environment are expected to contribute to Operating margin 9.1% 7.9% 8.2% LTL yield improvement. We implemented a general rate increase Average daily of 5.9%, effective June 14, 2004. Our no-fee money-back guaran- LTL shipments tee, implemented in September 2003, continues to be a differ- (in thousands) 58 56 56 4 – entiator in the market, generating additional business with new Weight per LTL and existing customers. Continued consolidation among carriers shipment (lbs) 1,127 1,114 1,114 1 – and an improving economy are providing many opportunities for LTL yield (revenue per FedEx Freight to promote its profitable interregional service. hundredweight) $14.23 $13.40 $12.41 6 8 In addition, through collaboration with other FedEx operating companies, FedEx Freight is increasing business levels with its FedEx Freight Segment Revenues major customers. Contributing to the positive outlook for 2005 is The double-digit increase in FedEx Freight segment revenues FedEx Freight’s disciplined approach to yield management, cou- during 2004 was primarily due to increases in LTL yield and LTL pled with strategic investments in capacity. average daily shipments. Year-over-year growth in LTL average daily shipments accelerated to 11% in the fourth quarter of 2004, FEDEX KINKO’S SEGMENT reflecting a strengthening economy and market-share gains. LTL The following table shows revenues, operating expenses and yield grew 6% during the year, reflecting incremental fuel sur- operating income and margin (dollars in millions) for the fourth charges due to higher fuel prices, growth in our interregional quarter ended May 31, 2004: freight service, a 5.9% general rate increase in June 2003 and Revenues $521 favorable contract renewals. In addition, 2004 had one additional Operating expenses: operating day. Revenues increased 8% during 2003 due to improved Salaries and employee benefits 185 LTL yield, despite the continued impact of a slow economy, severe Rentals 115 winter weather and one fewer operating day during the year. Depreciation and amortization 33 FedEx Freight Segment Operating Income Maintenance and repairs 9 The 26% increase in operating income at the FedEx Freight seg- Other 140 ment during 2004 was primarily attributable to LTL revenue growth Total operating expenses 482 and cost management. Operating margins improved as yield man- Operating income $39 agement and operational productivity gains outpaced increased Operating margin 7.5% incentive compensation, fuel, insurance and claims, pension and healthcare costs. Purchased transportation increased primarily

42 MANAGEMENT’S DISCUSSION AND ANALYSIS

FedEx Kinko’s Segment Operating Results FINANCIAL CONDITION The results of operations of FedEx Kinko’s are included in our LIQUIDITY consolidated results from the date of acquisition (February 12, Cash and cash equivalents totaled $1.046 billion at May 31, 2004, 2004). The FedEx Kinko’s segment was formed in the fourth quar- compared to $538 million at May 31, 2003. The following table ter of 2004. The results of operations from February 12, 2004 (the provides a summary of our cash flows for the years ended May 31 date of acquisition) through February 29, 2004 were included in (in millions): “Other and Eliminations” (approximately $100 million of revenue and $6 million of operating income). FedEx Kinko’s has focused 2004 2003 2002 on strengthening its current lines of business, which include Net cash provided by black-and-white, color and custom printing, copying and binding operating activities $ 3,020 $ 1,871 $ 2,228 services, facilities management and outsourcing, high-speed Investing activities: Internet access and computer usage, signs and graphics, sale of Business acquisition, net of retail products and others. Fourth quarter revenue was primarily cash acquired (2,410) – (35) driven by strong performance in signs and graphics, finishing ser- Capital expenditures and vices and retail products. As in-home technological advances other investing activities (1,252) (1,490) (1,577) have impacted the traditional retail walk-up business, FedEx Net cash used in investing activities (3,662) (1,490) (1,612) Kinko’s has expanded its efforts to attract a larger share of the Financing activities: commercial document solutions and business service market. Principal payments on debt (319) (10) (320) Proceeds from debt issuances 1,599 – – FedEx Kinko’s operating margin benefited from strong revenue Repurchase of treasury stock (179) (186) (177) performance during the fourth quarter. Additionally, our efforts to Dividends paid (66) (60) – optimize production machines within each store location resulted Other financing activities 115 82 91 in reduced lease and maintenance costs. Negatively impacting Net cash provided by (used in) operating margin was approximately $3 million of rebranding financing activities 1,150 (174) (406) costs. The caption “Other” in the financial summary on the Net increase in cash and preceding page includes supplies and other direct costs, such as cash equivalents $508 $ 207 $ 210 paper and toner. FedEx Kinko’s Segment Outlook The $1.149 billion increase in cash flows from operating activities In 2005, FedEx Kinko’s will focus on continuing to generate in 2004 was largely attributable to lower pension contributions. revenue growth by leveraging its new relationship with FedEx. Working capital management more than offset cash paid related FedEx Kinko’s plans to open approximately 70 new locations in to the business realignment initiatives. The $357 million decrease 2005, including many internationally. In addition, there are signifi- in cash flow provided by operating activities in 2003 reflected cant opportunities for growth in full-service color copies, finishing increased funding to our qualified pension plans, partially offset services and signs and graphics product offerings. We expect by improved earnings and lower levels of estimated federal operating margins to decrease in 2005, as FedEx Kinko’s will absorb income tax payments. Although not legally required, we made a portion of the FedEx Corporation headquarters’ fees commencing cash contributions to our qualified U.S. pension plans of $1.1 bil- in 2005 and approximately $20 million in rebranding costs. lion during 2003 (compared to $320 million in 2004 and $150 million in 2002). On April 26, 2004, we announced the new brand identity for FedEx Kinko’s retail locations – FedEx Kinko’s Office and Print Centers. Cash Used for Business Acquisitions. On February 12, 2004, we Following this announcement, we began accepting packages to acquired all of the common stock of FedEx Kinko’s for approxi- be shipped from our U.S. locations. This capability will also mately $2.4 billion in cash. See “Debt Financing Activities” and allow FedEx Kinko’s to launch “pack-and-ship” services in 2005. “FedEx Kinko’s Acquisition” for further discussion. During 2002, a Management is also focusing on cost reduction and control, with subsidiary of FedEx Trade Networks acquired certain assets of continued focus on machine optimization, increased opportunities Fritz Companies, Inc. at a cost of $36.5 million. See Note 2 of the for strategic sourcing of operating expenses such as supplies accompanying audited financial statements for further discus- and machines and implementing best practices across the FedEx sion of these acquisitions. Kinko’s network. Capital expenditures are expected to be approx- Cash Used for Capital Investments. For 2004, capital expenditures imately $125 million, primarily for technology- and equipment- declined due to lower aircraft expenditures at FedEx Express, related projects, real estate and rebranding. partially offset by an increase from network capacity expansion at FedEx Ground. Capital expenditures were also lower in 2003 due to management’s cost reduction actions in 2001 and 2002, despite deliveries of aircraft during 2003 that were scheduled and committed to well before the economic slowdown. See “Capital Resources” for further discussion.

43 FEDEX CORPORATION

Debt Financing Activities. Our commercial paper program is Dividends. Our Board of Directors declared our first-ever cash div- backed by unused commitments under two credit agreements, idend on May 31, 2002. Dividends paid in 2004 and 2003 were $66 totaling $1 billion, and reduces the amount available under these million and $60 million, respectively. On May 28, 2004, our Board of agreements. Commercial paper borrowings of $1.9 billion were Directors declared a dividend of $0.07 per share of common stock, necessary to finance part of our $2.4 billion acquisition of FedEx an increase of $0.01 per share over the previous dividend payment. Kinko’s. These borrowings were backed by a new six-month $2 The dividend was paid on July 1, 2004 to stockholders of record as billion credit agreement. During February 2004, we issued com- of the close of business on June 10, 2004. Each quarterly dividend mercial paper backed by unused commitments under this facility. payment is subject to review and approval by our Board of In March 2004, we issued $1.6 billion of senior unsecured notes Directors, and we intend to evaluate our dividend payment amount in three maturity tranches: one, three and five years, at $600 on an annual basis at the end of each fiscal year. million, $500 million and $500 million, respectively. These notes Other Liquidity Information. We believe that cash flow from oper- are guaranteed by all of our subsidiaries that are not considered ations, our commercial paper program and revolving bank credit minor under Securities and Exchange Commission (“SEC”) regu- facilities will adequately meet our working capital and capital lations. Net proceeds from these borrowings were used to repay expenditure needs for the foreseeable future. our commercial paper borrowings backed by the six-month facility. We canceled the six-month credit facility in March 2004. CAPITAL RESOURCES At May 31, 2004, no commercial paper borrowings were out- Despite the recent decrease in capital spending, our operations standing and the entire $1 billion under the revolving credit remain capital intensive, characterized by significant invest- agreements was available for future borrowings. Our debt and ments in aircraft, vehicles, computer hardware and software and revolving credit agreements contain certain covenants and telecommunications equipment, package-handling facilities restrictions, none of which are expected to affect our operations and sort equipment. The amount and timing of capital additions or ability to pay dividends. depend on various factors, including preexisting contractual During 2004, $250 million of senior unsecured notes matured and commitments, anticipated volume growth, domestic and inter- were paid. In addition, $25 million of existing unsecured debt at national economic conditions, new or enhanced services, FedEx Express matured and was paid. During the third quarter of geographical expansion of services, competition, availability of 2003, commercial paper borrowings of $200 million were necessary satisfactory financing and actions of regulatory authorities. to finance part of the cash contribution to our qualified pension The following table compares capital expenditures by asset plans. All of the commercial paper borrowings were repaid by category and reportable segment for the years ended May 31 (in April 11, 2003. At May 31, 2003, no commercial paper was out- millions): standing. For more information regarding our credit facilities, see Percent Change 2004/ 2003/ Note 6 of the accompanying audited financial statements. 2004 2003 2002 2003 2002 We have a $1.0 billion shelf registration statement with the SEC to Aircraft and related provide flexibility and efficiency when obtaining financing. Under equipment $ 372 $ 762 $ 730 (51) 4 this shelf registration statement we may issue, in one or more Facilities and sort offerings, either unsecured debt securities, common stock or a equipment 332 254 292 31 (13) combination of such instruments. The entire $1 billion is available Information technology for future financings. investments 249 273 288 (9) (5) Vehicles and other Cash Used for Share Repurchases. During 2004 and 2002, our equipment 318 222 305 43 (27) Board of Directors authorized us to buy back a total of 15.0 million Total capital shares of common stock. During the first half of 2004, we repur- expenditures $1,271 $1,511 $1,615 (16) (6) chased 2.6 million shares at an average price of $68.14 per share, which decreased cash flows by approximately $179 million. No FedEx Express segment $ 592 $ 917 $1,069 (35) (14) shares were repurchased during the second half of 2004. We FedEx Ground segment 314 252 214 25 18 repurchased 3.3 million shares in 2003 at an average price of $56.66 FedEx Freight segment 130 139 86 (6) 62 per share and this decreased cash flows by $186 million. During FedEx Kinko’s segment 36 ––n/a n/a 2002, we repurchased approximately 3.3 million shares of our com- Other 199 203 246 (2) (17) mon stock, at a cost of approximately $177 million or an average of Total capital $52.70 per share. Based on our current financing strategy, we have expenditures $1,271 $1,511 $1,615 (16) (6) significantly reduced the number of shares we expect to repur- chase and instead are issuing new shares in connection with our Capital expenditures were 16% lower in 2004, with the year-over- equity compensation programs. A total of 5.75 million shares year decrease due to lower aircraft expenditures at FedEx remain under existing share repurchase authorizations. Express, partially offset by an increase from network capacity expansion at FedEx Ground. Capital expenditures were 6% lower

44 MANAGEMENT’S DISCUSSION AND ANALYSIS

during 2003. This decrease was primarily at the FedEx Express Amounts Reflected in Balance Sheet segment, where capital expenditures were 14% lower. We con- We have other commercial commitments, not reflected in the tinued to make investments in FedEx Ground’s infrastructure and table above, that were incurred in the normal course of business information technology, and we also made capital investments to to support our operations, including surety bonds and standby let- expand FedEx Freight. ters of credit. These instruments are generally required under certain U.S. self-insurance programs and are used in the normal Our capital expenditures are expected to be approximately $1.65 course of international operations. While the notional amounts of billion in 2005, with much of the year-over-year increase coming these instruments are material, there are no additional contingent from planned aircraft expenditures at FedEx Express to support liabilities associated with them because the underlying liabilities IP volume growth. We also continue to invest in infrastructure are already reflected in our balance sheet. upgrades and scanning technologies, the multi-year capacity expansion of the FedEx Ground network, expansion of the FedEx We have certain operating leases that were arranged using vari- Kinko’s network and replacement vehicle needs at FedEx Freight. able interest entities under terms that are considered customary in the airline industry. As discussed in Note 16 to the accompa- Because of substantial lead times associated with the manufac- nying audited financial statements, we consolidated one of these ture or modification of aircraft, we must generally plan our entities in the second quarter of 2004 in accordance with FIN 46. aircraft orders or modifications three to eight years in advance. As a result of this consolidation, the accompanying audited May Therefore, we must make commitments regarding our airlift 31, 2004 balance sheet includes an additional $126 million of fixed requirements years before aircraft are actually needed. We are assets and $133 million of long-term liabilities, and the payment closely managing our capital spending based on current and of these debt obligations is included in the table above. anticipated volume levels and will defer or limit capital additions where economically feasible, while continuing to invest strategi- FedEx Express amended two leases for MD11 aircraft during 2004, cally in growing business segments. which required FedEx Express to record $110 million in both fixed assets and long-term liabilities. During 2003, FedEx Express CONTRACTUAL CASH OBLIGATIONS amended four leases for MD11 aircraft, which now commits FedEx The following table sets forth a summary of our contractual cash Express to firm purchase obligations for two of these aircraft obligations as of May 31, 2004. Certain of these contractual obli- during both 2005 and 2006. As a result, the amended leases were gations are reflected in our balance sheet, while others are accounted for as capital leases, which added $221 million to disclosed as future obligations under accounting principles both fixed assets and long-term liabilities at May 31, 2003. The generally accepted in the United States. Excluding the current future payments of these capital lease obligations are reflected portion of long-term debt and capital lease obligations, this table in the table above. does not include amounts already recorded on our balance sheet We have other long-term liabilities reflected in our balance sheet, as current liabilities at May 31, 2004. including deferred income taxes, pension and postretirement Payments Due by Fiscal Year healthcare liabilities and self-insurance accruals. The payment There- (in millions) 2005 2006 2007 2008 2009 after Total obligations associated with these liabilities are not reflected in Amounts reflected in Balance Sheet: the table above due to the absence of scheduled maturities. Long-term debt (1) $ 613 $ 265 $ 844 $ – $ 499 $ 832 $ 3,053 Therefore, the timing of these payments cannot be determined, Capital lease except for amounts estimated to be payable in 2005 that are obligations (2) 160 122 22 99 11 225 639 included in current liabilities.

Other cash obligations not reflected in Balance Sheet: Other Cash Obligations Not Reflected in Balance Sheet Unconditional The amounts reflected in the table above for purchase commit- purchase ments represent noncancelable agreements to purchase goods obligations (3) 601 255 252 212 643 1,439 3,402 or services. Such contracts include those for certain purchases Operating leases 1,707 1,555 1,436 1,329 1,169 7,820 15,016 of aircraft, aircraft modifications, vehicles, facilities, computers, Total $3,081 $2,197 $2,554 $1,640 $2,322 $10,316 $22,110 printing and other equipment and advertising and promotions contracts. Open purchase orders that are cancelable are not (1) Amounts do not include related interest. See Note 6 for the applicable interest rates. (2) Capital lease obligations represent principal and interest payments. considered unconditional purchase obligations for financial (3) See Note 17 to the accompanying audited financial statements. reporting purposes and are not included in the table above. Such purchase orders often represent authorizations to purchase We have certain contingent liabilities that are not accrued in our rather than binding agreements. balance sheet in accordance with accounting principles gener- ally accepted in the United States. These contingent liabilities are not included in the table above.

45 FEDEX CORPORATION

The amounts reflected in the table above for operating leases are material to our financial statements. Management has represent future minimum lease payments under noncancelable discussed the development and selection of these critical operating leases (principally aircraft and facilities) with an initial accounting policies and estimates with the Audit Committee of or remaining term in excess of one year at May 31, 2004. In the our Board of Directors and with our independent registered past, we financed a significant portion of our aircraft needs (and public accounting firm. certain other equipment needs) using operating leases (a type of “off-balance sheet financing”). At the time that the decision to PENSION COST lease was made, we determined that these operating leases We sponsor defined benefit pension plans covering a majority of would provide economic benefits favorable to ownership with our employees. The accounting for pension benefits is deter- respect to market values, liquidity and after-tax cash flows. mined by standardized accounting and actuarial methods that include numerous estimates, including: discount rates; expected In accordance with accounting principles generally accepted in long-term investment returns on plan assets; future salary the United States, our operating leases are not recorded in our increases; and employee turnover, mortality and retirement ages. balance sheet. Credit rating agencies routinely use this infor- mation concerning minimum lease payments required for our The determination of our annual pension cost is highly sensitive operating leases to calculate our debt capacity. In addition, we to changes in these estimates because we have a large, active have guarantees under certain operating leases, amounting to workforce and we have a significant amount of assets in the pen- $43 million as of May 31, 2004, for the residual values of vehicles sion plans. For example, only 6% of the participants covered and facilities at the end of the respective operating lease peri- under our principal pension plan are retired and currently receiv- ods. Based upon our expectation that none of these leased ing benefits and the average remaining service life of our assets will have a residual value at the end of the lease term that employees approximates 14 years (normal retirement is at age 60). is materially less than the value specified in the related operat- Therefore, the payout of pension benefits will occur over a long ing lease agreement, we do not believe it is probable that we will period in the future. This long-time period increases the sensitivity be required to fund any amounts under the terms of these of our annual pension cost to changes in these key estimates. guarantee arrangements. Accordingly, no accruals have been Total pension cost increased approximately $115 million in 2004 recognized for these guarantees. and approximately $80 million in 2003 primarily due to changes to these estimates. For 2005 we expect a smaller increase (approxi- In the future, other forms of secured financing and direct pur- mately $30 million), as 2004 actual asset returns have substantially chases may be used to obtain capital assets if we determine that improved the funded status of our pension plans in spite of a con- they best suit our needs. We have been successful in obtaining tinued decline in the discount rate. Pension cost is included in the investment capital, both domestic and international, for long-term salaries and employee benefits caption in our income statements. leases on acceptable terms, although the marketplace for such Following are the components of pension cost recognized in our capital can become restricted depending on a variety of eco- income statements (in millions): nomic factors. We believe the capital resources available to us provide flexibility to access the most efficient markets for financ- 2004 2003 2002 ing capital acquisitions, including aircraft, and are adequate for Service cost $376 $ 374 $ 348 our future capital needs. Interest cost 490 438 409 Expected return on plan assets (597) (594) (621) CRITICAL ACCOUNTING POLICIES AND ESTIMATES Net amortization and deferral 74 10 13 $343 $ 228 $ 149 The preparation of financial statements in accordance with accounting principles generally accepted in the United States Following is a discussion of the estimates we consider most crit- requires management to adopt accounting policies and make sig- ical to determining our pension costs: nificant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there Discount Rate. This is the interest rate used to discount the esti- are alternative policies or estimation techniques that could be mated future benefit payments that have been earned to date used. We maintain a thorough process to review the application (the projected benefit obligation) to their net present value. The of our accounting policies and to evaluate the appropriateness discount rate is determined each year at the plan measurement of the many estimates that are required to prepare the financial date (end of February) and affects the succeeding year’s pen- statements of a large, global corporation. However, even under sion cost. A decrease in the discount rate has a negative effect optimal circumstances, estimates routinely require adjustment on pension expense. based on changing circumstances and the receipt of new or This assumption is highly sensitive for us as a one-basis-point better information. change in the discount rate at February 29, 2004 affects our 2005 The policies and estimates discussed below include the financial pension expense by approximately $1.8 million and our 2004 statement elements that are either the most judgmental or involve accumulated benefit obligation by approximately $11 million. For the selection or application of alternative accounting policies and example, the 21-basis-point decrease in the discount rate to 6.78%

46 MANAGEMENT’S DISCUSSION AND ANALYSIS

for 2005 from 6.99% for 2004 will negatively affect our 2005 pen- Because of the introduction of the Portable Pension Account (dis- sion cost by approximately $38 million. Our 2004 pension cost was cussed below) for 2004 (which will reduce our liability duration negatively affected by approximately $20 million by the 12-basis- over time), as well as the significant additional contributions we point decrease in the discount rate to 6.99% for 2004 from 7.11% made into the plans in late 2003 and the continuing deterioration of for 2003. the equity markets through February 28, 2003, we performed a more recent asset/liability study for 2004, which supported a long- We determine the discount rate (which is required to be the rate at term return on assets of 9.10%. The results of this study were which the projected benefit obligation could be effectively settled reaffirmed for 2005 by our third-party professional investment as of the measurement date) with the assistance of actuaries, who advisors and actuaries and support our current asset allocation calculate the yield on a theoretical portfolio of high-grade corpo- strategy, which is summarized below: rate bonds with coupon payments and maturities that generally match our expected benefit payments. This methodology is Asset Class Target % of Plan Assets consistently applied and involves little subjectivity. However, the Domestic equities 53% calculated discount rate can change materially from year to year International equities 17 based on economic market conditions that impact yields on Private equities 5 corporate bonds. Total equities 75 Long duration fixed income securities 15 Plan Assets. Pension plan assets are invested primarily in listed Other fixed income securities 10 securities. Our pension plans hold only a minimal investment in 100% FedEx common stock. The estimated average rate of return on plan assets is a long-term, forward-looking assumption that also Our allocation of assets at February 29, 2004 approximates the materially affects our pension cost. It is intended to be the expected target allocation above. Our actual compound return on assets future long-term rate of earnings on plan assets. At February 29, was 9.4% for the 15-year period ended March 31, 2004. Based 2004, with over $7.7 billion of plan assets, a one-basis-point on these factors, we will retain 9.10% as our estimated future change in this assumption affects pension cost by approximately rate of return on pension assets for 2005. The 100-basis-point $750,000 (a decrease in the assumed expected long-term rate of decrease in the expected long-term rate of return for 2004 nega- return has a negative effect on pension expense). tively affected our 2004 pension cost by approximately $65 million. Establishing the expected future rate of investment return on our Our 2003 pension cost was negatively affected by approximately pension assets is a judgmental matter. Management considers $48 million by the 80-basis-point decrease in the expected long- the following factors in determining this assumption: term rate of return to 10.10% for 2003 from 10.90% for 2002. • the duration of our pension plan liabilities, which drives the Pension expense is also affected by the accounting policy used investment strategy we can employ with our pension plan assets. to determine the value of plan assets at the measurement date. We use a calculated-value method to determine the value of plan • the types of investment classes in which we invest our pension assets, which helps mitigate short-term volatility in market per- plan assets and the expected compound return we can reason- formance (both increases and decreases). Another method used ably expect those investment classes to earn over the next in practice applies the market value of plan assets at the mea- 10- to 15-year time period (or such other time period that may surement date. The application of the calculated-value method be appropriate). reduced 2004 and 2003 pension cost by approximately $106 • the investment returns we can reasonably expect our active million and $35 million, respectively. Application of the calculated- investment management program to achieve in excess of the value method will approximate the market-value method in 2005. returns we could expect if investments were made strictly in Salary Increases. The assumed future increase in salaries and indexed funds. wages is also a key estimate in determining pension cost. We cor- We review the expected long-term rate of return on an annual relate changes in estimated future salary increases to changes in basis and revise it as appropriate. Also, we periodically commis- the discount rate (since that is an indicator of general inflation and sion detailed asset/liability studies performed by third-party cost of living adjustments) and general estimated levels of prof- professional investment advisors and actuaries. These studies itability (since most incentive compensation is a component of project our estimated future pension payments and evaluate the pensionable wages). For 2005 pension cost, a one-basis-point efficiency of the allocation of our pension plan assets into various change in the rate of estimated future salaries affects pension investment categories. These studies also generate probability- cost by approximately $900,000 (a decrease in this rate will adjusted expected future returns on those assets. The study decrease pension cost). This assumption varies directly with the performed for 2003 supported the reasonableness of our 10.10% discount rate changes (reflecting general inflation trends); how- return assumption used for 2003 based on our liability duration and ever, the current rate is deemed to be at or near the floor based market conditions at the time we set this assumption (in 2002). on current pay structures and improving company performance.

47 FEDEX CORPORATION

Therefore, we will hold this assumption constant for determina- Cumulative unrecognized actuarial losses were approximately tion of 2005 pension cost. The decrease in this assumption to $1.7 billion through February 29, 2004, improved from $2.2 billion at 3.15% for 2004 from 3.25% favorably impacted 2004 pension cost February 28, 2003. These unrecognized losses primarily reflect the by approximately $10 million. declining discount rate and the declining stock market during 2003, 2002 and 2001. These amounts may be recovered in future Following is information concerning the funded status of our pen- periods through actuarial gains. However, to the extent that the sion plans as of May 31, 2004 and 2003 (in millions): discount rate remains low and market performance does not con- 2004 2003 tinue to improve, these unrecognized actuarial losses may be Funded Status of Plans: recognized in future periods. Accumulated benefit obligation (ABO): Qualified U.S. domestic plans $7,069 $ 5,725 The net amounts reflected in our balance sheet related to Other plans 358 284 pension items include a substantial prepaid pension asset. This Total ABO $7,427 $ 6,009 results from excess cash contributions to the plans over amounts Projected benefit obligation (PBO) $8,683 $ 7,117 that are recognized as pension expense for financial accounting Fair value of plan assets 7,783 5,825 purposes. Amounts accrued as liabilities (including minimum PBO in excess of plan assets (900) (1,292) pension liabilities) relate primarily to unfunded nonqualified plans Unrecognized actuarial losses, and international pension plans where additional funding may not principally due to investments provide a current tax deduction. and changes in discount rate 1,694 2,247 Effective in 2004, we amended the FedEx Corporation Employees’ Unamortized prior service cost and other 113 116 Pension Plan to add a cash balance feature, which we call the Amounts Included in Balance Sheets $ 907 $ 1,071 Portable Pension Account. We expect the Portable Pension Components of Amounts Included Account will help reduce the long-term growth of our pension lia- in Balance Sheets: bilities. All employees hired after May 31, 2003 will accrue Prepaid pension cost $1,127 $ 1,269 benefits under the Portable Pension Account formula. Eligible Accrued pension liability (220) (198) employees as of May 31, 2003 were able to choose between con- Minimum pension liability (67) (42) tinuing to accrue benefits under the traditional pension benefit Intangible asset and other 67 42 formula or accruing future benefits under the Portable Pension Net amounts recognized in balance sheets $ 907 $ 1,071 Account formula. The election was entirely optional. There was no conversion of existing accrued benefits to a cash balance. All Cash Amounts: benefits earned through May 31, 2003, including those applicable Cash contributions during the year $ 335 $ 1,072 to employees electing the Portable Pension Account, will be Benefit payments during the year $ 136 $ 103 determined under a traditional pension plan formula. Accordingly, it will be several years before the impact of the lower benefit pro- The funded status of the plans reflects a snapshot of the state of vided under this formula has a significant impact on our total our long-term pension liabilities at the plan measurement date. pension expense. Declining interest rates (which increase the discounted value of the PBO) and recent fluctuations in the stock market have signif- Under the Portable Pension Account, the retirement benefit is icantly impacted the funded status of our plans. However, our expressed as a dollar amount in a notional account that grows plans remain adequately funded to provide benefits to our employ- with annual credits based on pay, age and years of credited ser- ees as they come due and current benefit payments are nominal vice and interest on the notional account balance. An employee’s compared to our total plan assets (benefit payments for 2004 pay credits will be determined each year under a graded formula were less than 2% of plan assets at May 31, 2004). that combines age with years of service for points. The plan interest credit rate will vary from year to year based on the selected U.S. Although not legally required, we made $320 million in contri- Treasury maturity, with a 4% minimum and a maximum based on butions to our qualified U.S. pension plans in 2004 compared to the government rate. Employees are fully vested on completion of total contributions exceeding $1 billion in 2003. Our 2003 contri- five years of service. butions were made to ensure our qualified pension plan assets exceeded the related accumulated benefit obligations at our February 28, 2003 plan measurement date. Currently, we do not expect any contributions for 2005 will be legally required. Based on the substantial improvement in the funded status of our qualified plans, we do not currently expect to contribute any funds to our qualified defined benefit plans in 2005.

48 MANAGEMENT’S DISCUSSION AND ANALYSIS

SELF-INSURANCE ACCRUALS the gain or loss on the disposal of the asset. Historically, gains We are self-insured up to certain limits for costs associated with and losses on operating equipment have not been material (typ- workers’ compensation claims, vehicle accidents and general ically less than $10 million annually). However, such amounts business liabilities, and benefits paid under employee healthcare may differ materially in the future due to technological obso- and long-term disability programs. At May 31, 2004 there were lescence, accident frequency, regulatory changes and other approximately $1.03 billion of self-insurance accruals reflected in factors beyond our control. our balance sheet ($937 million at May 31, 2003). No material changes to the estimated lives and residual values The measurement of these costs requires the consideration of were made during 2004. At various times during 2003, as studies historical cost experience and judgments about the present and were completed, we made changes to the useful lives and resid- expected levels of cost per claim. We account for these costs pri- ual values of certain aircraft fleet types, as well as tractors, marily through actuarial methods, which develop estimates of the trailers and other equipment. These changes resulted in a undiscounted liability for claims incurred, including those claims decrease in 2003 depreciation expense of approximately $13 incurred but not reported. These methods provide estimates of million. Had all of these changes been made as of June 1, 2002, future ultimate claim costs based on claims incurred as of the depreciation expense for 2003 would have decreased by an balance sheet date. Other acceptable methods of accounting for additional $12 million. these accruals include measurement of claims outstanding and Because we must plan years in advance for future volume levels projected payments. and make commitments for aircraft based on those projections, We believe the use of actuarial methods to account for these lia- we have risks that asset capacity may exceed demand and that bilities provides a consistent and effective way to measure these an impairment of our assets may occur. The accounting test for highly judgmental accruals. However, the use of any estimation whether an asset held for use is impaired involves first comparing technique in this area is inherently sensitive given the magnitude the carrying value of the asset with its estimated future undis- of claims involved and the length of time until the ultimate cost is counted cash flows. If the cash flows do not exceed the carrying known. We believe our recorded obligations for these expenses value, the asset must be adjusted to its current fair value. are consistently measured on a conservative basis. Nevertheless, Because the cash flows of our transportation networks cannot changes in healthcare costs, accident frequency and sever- be identified to individual assets, and based on the ongoing ity, and other factors can materially affect the estimates for profitability of our operations, we have not experienced any sig- these liabilities. nificant impairment of assets to be held and used. However, from time to time we make decisions to remove certain long-lived LONG-LIVED ASSETS assets from service based on projections of reduced capacity Property and Equipment. Our key businesses are capital inten- needs and those decisions may result in an impairment charge. sive. More than 45% of our total assets are invested in our Assets held for disposal must be adjusted to their estimated fair transportation and information systems infrastructures. We cap- values when the decision is made to dispose of the asset and italize only those costs that meet the definition of capital assets certain other criteria are met. There were no material asset under accounting standards. Accordingly, repair and mainte- impairment charges recognized in 2004, 2003 or 2002. nance costs that do not extend the useful life of an asset are expensed as incurred. However, consistent with industry prac- Leases. We utilize operating leases to finance a significant num- tice, we capitalize certain aircraft-related costs on one of our ber of our aircraft and FedEx Kinko’s locations. Over the years, aircraft fleet types and amortize these costs over their estimated we have found these leasing arrangements to be favorable from service lives. a cash flow and risk management standpoint. Such arrange- ments typically shift the risk of loss on the residual value of the The depreciation or amortization of our capital assets over their assets at the end of the lease period to the lessor. As disclosed in estimated useful lives, and the determination of any salvage val- “Contractual Cash Obligations” and Note 7 to the accompanying ues, requires management to make judgments about future audited financial statements, at May 31, 2004 we had approx- events. Because we utilize many of our capital assets over rela- imately $15 billion (on an undiscounted basis) of future commit- tively long periods (the majority of aircraft costs are depreciated ments for payments under operating leases. over 15 to 18 years), we periodically evaluate whether adjust- ments to our estimated service lives or salvage values are The future commitments for operating leases are not reflected as necessary to ensure these estimates properly match the eco- a liability in our balance sheet because the leases do not meet nomic use of the asset. This evaluation may result in changes in the accounting definition of capital leases. The determination of the estimated lives and residual values used to depreciate our whether a lease is accounted for as a capital lease or an operat- aircraft and other equipment. These estimates affect the amount ing lease requires management to make estimates primarily about of depreciation expense recognized in a period and, ultimately, the fair value of the asset and its estimated economic useful life.

49 FEDEX CORPORATION

We believe we have well-defined and controlled processes for REVENUE RECOGNITION making this evaluation, including obtaining third-party appraisals We believe the policies adopted to recognize revenue are criti- for material transactions. cal because an understanding of the accounting applied in this area is fundamental to assessing our overall financial perfor- Goodwill. We have approximately $2.8 billion of goodwill on our mance and because revenue and revenue growth are key balance sheet resulting from the acquisition of businesses, which measures of financial performance in the marketplace. Our busi- includes approximately $1.7 billion from our acquisition of FedEx nesses are primarily involved in the direct pickup and delivery of Kinko’s in 2004. New accounting standards adopted in 2002 require commercial package and freight shipments, as well as providing that we review this goodwill for impairment on an annual basis and document solutions and business services. Our employees and cease all goodwill amortization. As previously indicated, the adop- agents are involved throughout the process and our operational, tion of these new rules resulted in an impairment of our recorded billing and accounting systems directly capture and control all goodwill of $25 million in 2002 at one of our smaller businesses. relevant information necessary to record revenue, bill customers The annual evaluation of goodwill impairment requires the use of and collect amounts due to us. estimates and assumptions to determine the fair value of our We recognize revenue upon delivery of shipments or, for our busi- reporting units using a discounted cash flow methodology. In par- ness services, logistics and trade services businesses, upon the ticular, the following estimates used by management can completion of services. Transportation industry practice includes significantly affect the outcome of the impairment test: revenue two predominant methods for revenue recognition for shipments growth rates; operating margin; discount rates and expected in process at the end of an accounting period: (1) recognize capital expenditures. Each year, independent of our goodwill all revenue and the related delivery costs when shipments are impairment test, we update our weighted-average cost of capital delivered or (2) recognize a portion of the revenue earned for ship- calculation and perform a long-range planning analysis to project ments that have been picked up but not yet delivered at period expected results of operations. Using this data, we complete a end and accrue delivery costs as incurred. We use the second separate analysis for each of our reporting units. Changes in fore- method; we recognize the portion of revenue earned at the bal- casted operations and other assumptions could materially affect ance sheet date for shipments in transit and accrue all delivery these estimates. We compare the fair value of our reporting units costs as incurred. We believe this accounting policy effectively to the carrying value, including goodwill, of each of those units. and consistently matches revenue with expenses and recognizes Since the acquisition of FedEx Kinko’s occurred near the end of liabilities as incurred. 2004, we did not test its goodwill for impairment in 2004. We will include the related goodwill in our 2005 annual impairment test, There are three key estimates that are included in the recognition which, unless circumstances otherwise dictate, will be performed and measurement of our revenue and related accounts receivable in the fourth quarter of 2005. We performed our annual impairment under the policies described above: (1) estimates for unbilled rev- tests in 2004 and 2003 for our other reporting units. The fair value enue on shipments that have been delivered; (2) estimates for of our reporting units exceeded the carrying value, including revenue associated with shipments in transit; and (3) estimates goodwill, of each of those units; therefore, no impairment charge for future adjustments to revenue or accounts receivable for was necessary. billing adjustments and bad debts. Intangible Asset with an Indefinite Life. The estimated fair value Unbilled Revenue. Primarily due to cycle billings to some of our of our intangible asset with an indefinite life was $567 million, con- larger customers, there is a time lag between the completion of a sisting of the estimated fair value allocated to the Kinko’s trade shipment and the generation of an invoice. At the end of a month, name. This intangible asset will not be amortized because it has unprocessed invoices may be as much as one-third of the total an indefinite remaining useful life based on the length of time that month’s revenue. This revenue is recognized through systematic the Kinko’s name had been in use, the Kinko’s brand awareness accrual processes. Invoices that are essentially complete repre- and market position and the plans for continued use of the Kinko’s sent most of these accruals, with little subjectivity over the brand. We must review this asset for impairment on an annual amounts accrued. The remaining amounts are estimated using basis. This annual evaluation requires the use of estimates about actual package or shipment volumes and current trends of aver- the future cash flows attributable to the Kinko’s trade name to age revenue per shipment. These estimates are adjusted in determine the estimated fair value of the trade name. Changes in subsequent months to the actual amounts invoiced. Because of forecasted operations and changes in discount rates can materi- the low level of subjectivity inherent in these accrual processes, ally affect this estimate. However, once an impairment of this the estimates have historically not varied significantly from actual intangible asset has been recorded, it cannot be reversed. Unless amounts subsequently invoiced. circumstances otherwise dictate, we plan to perform our first annual impairment test in the fourth quarter of 2005.

50 MANAGEMENT’S DISCUSSION AND ANALYSIS

Shipments in Process. The majority of our shipments have short are denominated in U.S. dollars. The distribution of our foreign cycle times; therefore, less than 5% of a total month’s revenue is currency denominated transactions is such that currency typically in transit at the end of a period. We periodically perform declines in some areas of the world are often offset by currency studies to measure the percentage of completion for shipments in gains of equal magnitude in other areas of the world. The princi- process. At month-end, we estimate the amount of revenue pal foreign currency exchange rate risks to which we are earned on shipments in process based on actual shipments exposed are in the Japanese yen, Taiwan dollar, Canadian dollar picked up, the scheduled day of delivery, the day of the week on and euro. During 2004 and 2003, we believe operating income which the month ends (which affects the percentage of comple- was positively impacted due to foreign currency fluctuations. tion) and current trends in our average price for the respective However, favorable foreign currency fluctuations also may have services. We believe these estimates provide a reasonable had an offsetting impact on the price we obtained or the demand approximation of the actual revenue earned at the end of a period. for our services. At May 31, 2004, the result of a uniform 10% strengthening in the value of the dollar relative to the currencies Future Adjustments to Revenue and Accounts Receivable. Like in which our transactions are denominated would result in a many companies, we experience some credit loss on our trade decrease in operating income of approximately $79 million for accounts receivable. Historically, our credit losses from bad debts 2005 (the comparable amount in the prior year was approximately have not fluctuated materially because our credit management $36 million). This increase is primarily due to the strong growth processes have been highly effective. We also recognize billing of our international operations. This theoretical calculation adjustments to revenue and accounts receivable for certain dis- assumes that each exchange rate would change in the same counts, money-back service guarantees and billing corrections. direction relative to the U.S. dollar. Estimates for credit losses and billing adjustments are regularly In practice, our experience is that exchange rates in the principal updated based on historical experience of bad debts, adjustments foreign markets where we have foreign currency denominated processed and current collections trends. Total allowances for transactions tend to have offsetting fluctuations. Therefore, the these future adjustments were $151 million at May 31, 2004 and calculation above is not indicative of our actual experience in for- $149 million at May 31, 2003. We consider the sensitivity and eign currency transactions. In addition to the direct effects of subjectivity of these estimates to be moderate, as changes in changes in exchange rates, which are a changed dollar value of economic conditions, pricing arrangements and billing systems the resulting reported operating results, changes in exchange can significantly affect the estimates used to determine the rates also affect the volume of sales or the foreign currency sales allowances. price as competitors’ services become more or less attractive. The sensitivity analysis of the effects of changes in foreign cur- MARKET RISK SENSITIVE INSTRUMENTS AND POSITIONS rency exchange rates does not factor in a potential change in While we currently have market risk sensitive instruments related sales levels or local currency prices. to interest rates, we have no significant exposure to changing We have market risk for changes in the price of jet and diesel interest rates on our long-term debt because the interest rates are fuel; however, this risk is largely mitigated by revenue from our fixed on the majority of our long-term debt. We had approximately fuel surcharges. In 2002, we implemented new indices for calcu- $730 million of outstanding floating-rate borrowings at May 31, lating U.S. domestic fuel surcharges, which more closely link the 2004. We have not employed interest rate hedging to mitigate the fuel surcharges to prevailing market prices for fuel. In 2003, we risks with respect to these borrowings. A hypothetical 10% implemented this methodology for determining a fuel surcharge increase in the interest rate on our outstanding floating-rate bor- on international shipments as well. Therefore, a hypothetical 10% rowings would not have a material effect on our results of change in the price of fuel would not be expected to materially operations. As disclosed in Note 6 to the accompanying audited affect our earnings. However, our fuel surcharges have a lag that financial statements, we had outstanding fixed-rate, long-term exists before they are adjusted for changes in jet fuel prices and debt (exclusive of capital leases) of $2.3 billion at May 31, 2004 and fuel prices can fluctuate within certain ranges before resulting in $1.6 billion at May 31, 2003. Market risk for fixed-rate, long-term a change in our fuel surcharges. Therefore, our operating income debt is estimated as the potential decrease in fair value resulting may be affected should the spot price of fuel suddenly change by from a hypothetical 10% increase in interest rates and amounts to a significant amount or change by amounts that do not result in a approximately $49 million as of May 31, 2004 and $39 million as of change in our fuel surcharges. May 31, 2003. The underlying fair values of our long-term debt were estimated based on quoted market prices or on the current We do not purchase or hold any derivative financial instruments rates offered for debt with similar terms and maturities. for trading purposes. While we are a global provider of transportation, e-commerce and business services, the substantial majority of our transactions

51 FEDEX CORPORATION

FORWARD-LOOKING STATEMENTS • the outcome of negotiations to reach a new collective bargain- ing agreement with the union that represents the pilots of FedEx Certain statements in this report, including (but not limited to) Express; those contained in “Business Realignment Costs,” “FedEx Kinko’s Acquisition,” “Airline Stabilization Compensation,” “Outlook,” • market acceptance of our new service and growth initiatives; “Reportable Segments,” “Liquidity,” “Capital Resources,” • competition from other providers of transportation, e-commerce “Contractual Cash Obligations” and “Critical Accounting Policies and business services, including our ability to compete with and Estimates,” are “forward-looking” statements within the new or improved services offered by our competitors; meaning of the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, cash • the impact of technology developments on our operations and flows, plans, objectives, future performance and business of on demand for our services; FedEx. Forward-looking statements include those preceded by, • disruptions to our technology infrastructure, including our com- followed by or that include the words “may,” “could,” “would,” puter systems and Web site; “should,”“believes,”“expects,”“anticipates,”“plans,”“estimates,” “targets,”“projects,”“intends” or similar expressions. These for- • our ability to obtain and maintain aviation rights in important ward-looking statements involve risks and uncertainties. Actual international markets; results may differ materially from those contemplated (expressed • adverse weather conditions or natural disasters; or implied) by such forward-looking statements, because of, among other things, potential risks and uncertainties, such as: • availability of financing on terms acceptable to us and our ability to maintain our current credit ratings; and • economic conditions in the domestic and international markets in which we operate; • other risks and uncertainties you can find in our press releases and SEC filings. • any impacts on our business resulting from new domestic or international government regulation, including regulatory actions As a result of these and other factors, no assurance can be given affecting aviation rights and labor rules; as to our future results and achievements. Accordingly, a forward- looking statement is neither a prediction nor a guarantee of future • the impact of any international conflicts or terrorist activities or events or circumstances and those future events or circum- related security measures on the United States and global stances may not occur. You should not place undue reliance on economies in general, or the transportation industry in particu- the forward-looking statements, which speak only as of the date lar, and what effects these events will have on our costs or the of this report. We are under no obligation, and we expressly demand for our services; disclaim any obligation, to update or alter any forward-looking • our ability to manage our cost structure for capital expenditures statements, whether as a result of new information, future events and operating expenses and match them, especially those relat- or otherwise. ing to aircraft, vehicle and sort capacity, to shifting customer volume levels; • our ability to effectively operate, integrate and leverage the FedEx Kinko’s business; • sudden changes in fuel prices or currency exchange rates; • our ability to increase our fuel surcharges in response to rising fuel prices due to competitive pressures; • significant changes in the volumes of shipments transported through our networks, the mix of services purchased by our customers or the prices we obtain for our services; • the amount of compensation we are entitled to receive and retain under the Air Transportation Safety and System Stabilization Act;

52 FEDEX CORPORATION

CONSOLIDATED STATEMENTS OF INCOME Years ended May 31, (In millions, except per share amounts) 2004 2003 2002 REVENUES $24,710 $22,487 $20,607 Operating Expenses: Salaries and employee benefits 10,728 9,778 9,099 Purchased transportation 2,407 2,155 1,825 Rentals and landing fees 1,918 1,803 1,780 Depreciation and amortization 1,375 1,351 1,364 Fuel 1,481 1,349 1,100 Maintenance and repairs 1,523 1,398 1,240 Business realignment costs 435 –– Airline stabilization compensation – – (119) Other 3,403 3,182 2,997 23,270 21,016 19,286

OPERATING INCOME 1,440 1,471 1,321 Other Income (Expense): Interest expense (136) (124) (144) Interest income 20 65 Other, net (5) (15) (22) (121) (133) (161) Income Before Income Taxes 1,319 1,338 1,160 Provision for Income Taxes 481 508 435 Income Before Cumulative Effect of Change in Accounting Principle 838 830 725 Cumulative Effect of Change in Accounting for Goodwill, Net of Tax Benefit of $10 – – (15) NET INCOME $ 838 $830 $710 BASIC EARNINGS PER COMMON SHARE: Income before cumulative effect of change in accounting principle $ 2.80 $ 2.79 $ 2.43 Cumulative effect of change in accounting for goodwill – – (0.05) Basic Earnings Per Common Share $ 2.80 $ 2.79 $ 2.38 DILUTED EARNINGS PER COMMON SHARE: Income before cumulative effect of change in accounting principle $ 2.76 $ 2.74 $ 2.39 Cumulative effect of change in accounting for goodwill – – (0.05) Diluted Earnings Per Common Share $ 2.76 $ 2.74 $ 2.34

The accompanying notes are an integral part of these consolidated financial statements.

53 FEDEX CORPORATION

CONSOLIDATED BALANCE SHEETS May 31, (In millions, except share data) 2004 2003 ASSETS Current Assets Cash and cash equivalents $ 1,046 $538 Receivables, less allowances of $151 and $149 3,027 2,627 Spare parts, supplies and fuel, less allowances of $124 and $101 249 228 Deferred income taxes 489 416 Prepaid expenses and other 159 132 Total current assets 4,970 3,941 Property and Equipment, at Cost Aircraft and related equipment 7,001 6,624 Package handling and ground support equipment and vehicles 5,296 5,013 Computer and electronic equipment 3,537 3,180 Other 4,477 4,200 20,311 19,017 Less accumulated depreciation and amortization 11,274 10,317 Net property and equipment 9,037 8,700 Other Long-Term Assets Goodwill 2,802 1,063 Prepaid pension cost 1,127 1,269 Intangible and other assets 1,198 412 Total other long-term assets 5,127 2,744 $19,134 $15,385 LIABILITIES AND STOCKHOLDERS’ INVESTMENT Current Liabilities Current portion of long-term debt $750 $308 Accrued salaries and employee benefits 1,062 724 Accounts payable 1,615 1,168 Accrued expenses 1,305 1,135 Total current liabilities 4,732 3,335 Long-Term Debt, Less Current Portion 2,837 1,709 Other Long-Term Liabilities Deferred income taxes 1,181 882 Pension, postretirement healthcare and other benefit obligations 768 657 Self-insurance accruals 591 536 Deferred lease obligations 503 466 Deferred gains, principally related to aircraft transactions 426 455 Other liabilities 60 57 Total other long-term liabilities 3,529 3,053 Commitments and Contingencies Common Stockholders’ Investment Common stock, $0.10 par value; 800 million shares authorized; 300 million shares issued for 2004 and 299 million shares issued for 2003 30 30 Additional paid-in capital 1,079 1,088 Retained earnings 7,001 6,250 Accumulated other comprehensive loss (46) (30) 8,064 7,338 Less deferred compensation and treasury stock, at cost 28 50 Total common stockholders’ investment 8,036 7,288 $19,134 $15,385

The accompanying notes are an integral part of these consolidated financial statements.

54 FEDEX CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended May 31, (In millions) 2004 2003 2002 OPERATING ACTIVITIES Net income $ 838 $ 830 $ 710 Adjustments to reconcile net income to cash provided by operating activities: Depreciation and amortization 1,375 1,351 1,364 Provision for uncollectible accounts 106 105 110 Deferred income taxes and other noncash items (8) 329 84 Cumulative effect of change in accounting principle – – 15 Tax benefit on the exercise of stock options 43 20 18 Changes in operating assets and liabilities, net of the effects of businesses acquired: Receivables (307) (197) (88) Other current assets 10 39 63 Pension assets and liabilities, net 155 (854) (13) Accounts payable and other operating liabilities 841 252 (37) Other, net (33) (4) 2 Cash provided by operating activities 3,020 1,871 2,228 INVESTING ACTIVITIES Business acquisitions, net of cash acquired (2,410) – (35) Capital expenditures (1,271) (1,511) (1,615) Proceeds from asset dispositions 18 22 27 Other, net 1 (1) 11 Cash used in investing activities (3,662) (1,490) (1,612) FINANCING ACTIVITIES Principal payments on debt (319) (10) (320) Proceeds from debt issuances 1,599 –– Proceeds from stock issuances 115 81 88 Dividends paid (66) (60) – Purchase of treasury stock (179) (186) (177) Other, net – 13 Cash provided by (used in) financing activities 1,150 (174) (406) CASH AND CASH EQUIVALENTS Net increase in cash and cash equivalents 508 207 210 Cash and cash equivalents at beginning of period 538 331 121 Cash and cash equivalents at end of period $ 1,046 $538 $331

The accompanying notes are an integral part of these consolidated financial statements.

55 FEDEX CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ INVESTMENT AND COMPREHENSIVE INCOME Accumulated Additional Other Common Paid-in Retained Comprehensive Treasury Deferred (In millions, except share data) Stock Capital Earnings Loss Stock Compensation Total BALANCE AT MAY 31, 2001 $ 30 $1,120 $4,880 $(56) $ (53) $(21) $5,900 Net income – – 710 – – – 710 Foreign currency translation adjustment, net of deferred taxes of $1 ––– 6––6 Minimum pension liability adjustment, net of deferred tax benefit of $2 – – – (3) – – (3) Reclassification of deferred jet fuel hedging charges, net of deferred tax benefit of $6 – – – (9) – – (9) Adjustment for jet fuel hedging charges recognized in expense during period, net of deferred taxes of $6 ––– 9––9 Total comprehensive income 713 Purchase of treasury stock – – – – (177) – (177) Cash dividends declared ($0.05 per share) – – (15) – – – (15) Employee incentive plans and other (4,224,444 shares issued) – 24 (110) – 210 (12) 112 Amortization of deferred compensation – – – – – 12 12 BALANCE AT MAY 31, 2002 30 1,144 5,465 (53) (20) (21) 6,545 Net income – – 830 – – – 830 Foreign currency translation adjustment, net of deferred taxes of $10 – – – 37 – – 37 Minimum pension liability adjustment, net of deferred tax benefit of $7 – – – (14) – – (14) Total comprehensive income 853 Purchase of treasury stock – – – – (186) – (186) Cash dividends declared ($0.15 per share) – – (45) – – – (45) Employee incentive plans and other (3,268,180 shares issued) – (56) – – 181 (16) 109 Amortization of deferred compensation –––––1212 BALANCE AT MAY 31, 2003 30 1,088 6,250 (30) (25) (25) 7,288 Net income – – 838 – – – 838 Minimum pension liability adjustment, net of deferred tax benefit of $12 – – – (16) – – (16) Total comprehensive income 822 Purchase of treasury stock – – – – (179) – (179) Cash dividends declared ($0.29 per share) – – (87) – – – (87) Employee incentive plans and other (4,013,182 shares issued) – (9) – – 204 (18) 177 Amortization of deferred compensation – – – – – 15 15 BALANCE AT MAY 31, 2004 $30 $1,079 $7,001 $(46) $ – $(28) $8,036

The accompanying notes are an integral part of these consolidated financial statements.

56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1: DESCRIPTION OF BUSINESS AND SUMMARY OF REVENUE RECOGNITION SIGNIFICANT ACCOUNTING POLICIES Revenue is recognized upon delivery of shipments or the com- pletion of the service for our office and print services, logistics DESCRIPTION OF BUSINESS and trade services businesses. For shipments in transit, revenue FedEx Corporation (“FedEx”) provides a broad portfolio of trans- is recorded based on the percentage of service completed at the portation, e-commerce and business services with companies balance sheet date. Estimates for future billing adjustments to that operate independently and compete collectively under the revenue and accounts receivable are recognized at the time of respected FedEx brand. Our operations are primarily represented shipment for certain discounts, money-back service guarantees by Federal Express Corporation (“FedEx Express”), the world’s and billing corrections. Delivery costs are accrued as incurred. largest express transportation company; FedEx Ground Package System, Inc. (“FedEx Ground”), North America’s second largest Our contract logistics and global trade services businesses engage provider of small-package ground delivery service; FedEx Freight in certain transactions wherein they act as agents. Revenue from Corporation (“FedEx Freight”), a leading U.S. provider of regional these transactions is recorded on a net basis. less-than-truckload (“LTL”) freight services; and FedEx Kinko’s Office and Print Services, Inc. (“FedEx Kinko’s”), a leading provider ADVERTISING of document solutions and business services. These businesses Advertising costs are expensed as incurred and are classified in form the core of our reportable segments. Other business units other operating expenses. Advertising expenses were $284 million, in the FedEx portfolio are FedEx Trade Networks, Inc. (“FedEx $249 million and $226 million in 2004, 2003 and 2002, respectively. Trade Networks”), a global trade services company; FedEx Supply Chain Services, Inc. (“FedEx Supply Chain Services”), a contract CASH EQUIVALENTS logistics provider; FedEx Custom Critical, Inc. (“FedEx Custom Cash equivalents in excess of current operating requirements are Critical”), a critical-shipment carrier; Caribbean Transportation invested in short-term, interest-bearing instruments with maturi- Services, Inc. (“Caribbean Transportation Services”), a provider ties of three months or less at the date of purchase and are of airfreight forwarding services, and FedEx Corporate Services, stated at cost, which approximates market value. Inc. (“FedEx Services”), a provider of customer-facing sales, mar- keting and information technology functions, primarily for FedEx SPARE PARTS, SUPPLIES AND FUEL Express and FedEx Ground. Spare parts are stated principally at weighted-average cost. Supplies and fuel are stated principally at standard cost, which The FedEx Kinko’s segment was formed in the fourth quarter of 2004 approximates actual cost on a first-in, first-out basis. Allowances as a result of our acquisition of FedEx Kinko’s (formerly known as for obsolescence are provided, over the estimated useful life of Kinko’s, Inc.). As discussed in Note 2, we acquired FedEx Kinko’s on the related aircraft and engines, for spare parts expected to be February 12, 2004, and its results of operations have been included on hand at the date the aircraft are retired from service, and for in our financial results from the date of acquisition. spare parts currently identified as excess or obsolete. These allowances are based on management estimates, which are FISCAL YEARS subject to change. Except as otherwise specified, references to years indicate our fiscal year ended May 31, 2004 or ended May 31 of the year PROPERTY AND EQUIPMENT referenced. Expenditures for major additions, improvements, flight equipment modifications and certain equipment overhaul costs are capital- PRINCIPLES OF CONSOLIDATION ized when such costs are determined to extend the useful life of The consolidated financial statements include the accounts of the asset. Maintenance and repairs are charged to expense as FedEx and its subsidiaries, substantially all of which are wholly incurred, except for certain aircraft-related costs on one of our owned. All significant intercompany accounts and transactions aircraft fleet types, which are capitalized and amortized over their have been eliminated. estimated service lives. We capitalize certain direct internal and external costs associated with the development of internal use CREDIT RISK software. The cost and accumulated depreciation of property and We routinely grant credit to many of our customers for trans- equipment disposed of are removed from the related accounts, portation and business services without collateral. The risk of and any gain or loss is reflected in the results of operations. credit loss in our trade receivables is substantially mitigated by Gains and losses on sales of property used in operations are our credit evaluation process, short collection terms and sales to classified with depreciation and amortization. a large number of customers, as well as the low revenue per transaction for most of our services. Allowances for potential credit losses are determined based on historical experience, current evaluation of the composition of accounts receivable and expected credit trends. Historically, credit losses have been within management’s expectations.

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For financial reporting purposes, depreciation and amortization future salary increases, future expected long-term returns on of property and equipment is provided on a straight-line basis plan assets and future increases in healthcare costs. Discount over the asset’s service life or related lease term as follows: rates are established as of the measurement date using theoret-

Range ical bond models that select high-grade corporate bonds with Wide-body aircraft and related equipment 15 to 25 years maturities or coupons that correlate to the expected payouts of Narrow-body and feeder aircraft the applicable liabilities. Assets for funded plans are presented and related equipment 5 to 15 years at fair value at the measurement date in the accompanying foot- Package handling and ground support notes. A calculated-value method is employed for purposes of equipment and vehicles 3 to 30 years determining the expected return on the plan asset component of Computer and electronic equipment 3 to 10 years net periodic pension cost for our qualified U.S. pension plans. Other 2 to 40 years Generally, we do not fund defined benefit plans when such fund- ing provides no current tax deduction. Substantially all property and equipment have no material residual values. The majority of aircraft costs are depreciated on a straight- GOODWILL Goodwill is recognized for the excess of the purchase price over line basis over 15 to 18 years, while vehicles are depreciated on a the fair value of tangible and identifiable intangible net assets of straight-line basis over five to ten years. We periodically evaluate businesses acquired. Goodwill is reviewed at least annually for the estimated service lives and residual values used to depreciate impairment. Unless circumstances otherwise dictate, we perform our aircraft and other equipment. This evaluation may result in our annual impairment testing in the fourth quarter. changes in the estimated lives and residual values. The changes did not materially affect depreciation expense in any period pre- INTANGIBLE ASSETS sented. Depreciation expense, excluding gains and losses on Amortizable intangible assets include customer relationships, sales of property and equipment used in operations, was $1.361 contract based, technology based and other. Amortizable intan- billion, $1.334 billion and $1.331 billion in 2004, 2003 and 2002, gible assets are amortized over periods ranging from 2 to 15 years, respectively. Depreciation and amortization expense includes either on a straight-line basis or an accelerated basis using the amortization of assets under capital lease. pattern in which the economic benefits are consumed. Non- For income tax purposes, depreciation is generally computed amortizing intangible assets include the Kinko’s trade name. using accelerated methods. Non-amortizing intangibles are reviewed at least annually for impairment. Unless circumstances otherwise dictate, we perform CAPITALIZED INTEREST our annual impairment testing in the fourth quarter. Interest on funds used to finance the acquisition and modification of aircraft, construction of certain facilities and development of INCOME TAXES certain software up to the date the asset is ready for its intended Deferred income taxes are provided for the tax effect of tempo- use is capitalized and included in the cost of the asset. Cap- rary differences between the tax basis of assets and liabilities and italized interest was $11 million in 2004, $16 million in 2003 and their reported amounts in the financial statements. The liability $27 million in 2002. method is used to account for income taxes, which requires deferred taxes to be recorded at the statutory rate to be in effect IMPAIRMENT OF LONG-LIVED ASSETS when the taxes are paid. Long-lived assets are reviewed for impairment when circum- We have not recognized deferred taxes for U.S. federal income stances indicate the carrying value of an asset may not be taxes on foreign subsidiaries’ earnings that are deemed to be recoverable. For assets that are to be held and used, an impair- permanently reinvested and any related taxes associated with ment is recognized when the estimated undiscounted cash flows such earnings are not material. Pretax earnings of foreign opera- associated with the asset or group of assets is less than their tions for 2004 and 2003 were approximately $430 million and $140 carrying value. If impairment exists, an adjustment is made to million, respectively, which represent only a portion of total write the asset down to its fair value, and a loss is recorded as results associated with international shipments. the difference between the carrying value and fair value. Fair val- ues are determined based on quoted market values, discounted SELF-INSURANCE ACCRUALS cash flows or internal and external appraisals, as applicable. We are primarily self-insured for workers’ compensation claims, Assets to be disposed of are carried at the lower of carrying vehicle accidents and general liabilities, benefits paid under value or estimated net realizable value. employee healthcare programs and long-term disability. Accruals are primarily based on the actuarially estimated, undiscounted PENSION AND POSTRETIREMENT HEALTHCARE PLANS cost of claims, which includes incurred-but-not-reported claims. These defined benefit plans are measured as of the last day of Current workers’ compensation claims, vehicle and general lia- our fiscal third quarter of each year using actuarial techniques bility, employee healthcare claims and long-term disability are that reflect estimates for mortality, turnover and expected retire- included in accrued expenses. ment. In addition, management makes assumptions concerning

58 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DEFERRED LEASE OBLIGATIONS See Note 9 for a discussion of the assumptions underlying the pro While certain aircraft, facility and retail location leases contain forma calculations above. fluctuating or escalating payments, the related rent expense is recorded on a straight-line basis over the lease term. The deferred FOREIGN CURRENCY TRANSLATION lease obligation is the net cumulative excess of rent expense over Translation gains and losses of foreign operations that use local rent payments. currencies as the functional currency are accumulated and reported, net of applicable deferred income taxes, as a compo- DEFERRED GAINS nent of accumulated other comprehensive loss within common Gains on the sale and leaseback of aircraft and other property stockholders’ investment. Transaction gains and losses that arise and equipment are deferred and amortized ratably over the life from exchange rate fluctuations on transactions denominated in of the lease as a reduction of rent expense. Substantially all of a currency other than the local currency are included in results of these deferred gains were related to aircraft transactions. operations. Cumulative net foreign currency translation losses in accumulated other comprehensive loss were $13 million, $13 mil- EMPLOYEES UNDER COLLECTIVE BARGAINING lion and $50 million at May 31, 2004, 2003 and 2002, respectively. ARRANGEMENTS The pilots of FedEx Express, which represent a small number of RECLASSIFICATIONS FedEx Express total employees, are employed under a collective Certain reclassifications have been made to prior year financial bargaining agreement. Negotiations with the pilots’ union began statements to conform to the current year presentation. in March 2004, as the current agreement became amendable on May 31, 2004. We will continue to operate under our current USE OF ESTIMATES agreement while we negotiate with our pilots. The preparation of our consolidated financial statements requires the use of estimates and assumptions that affect the reported STOCK COMPENSATION amounts of assets and liabilities, the reported amounts of rev- We apply Accounting Principles Board Opinion No. (“APB”) 25, enues and expenses and the disclosure of contingent liabilities. “Accounting for Stock Issued to Employees,” and its related inter- Management makes its best estimate of the ultimate outcome for pretations to measure compensation expense for stock-based these items based on historical trends and other information compensation plans. We are required to disclose the pro forma available when the financial statements are prepared. Changes in effect of accounting for stock options using a valuation method estimates are recognized in accordance with the accounting under Statement of Financial Accounting Standards No. (“SFAS”) rules for the estimate, which is typically in the period when new 123, “Accounting for Stock-Based Compensation,” for all options information becomes available to management. Areas where the granted in 1996 and thereafter. We have currently not elected to nature of the estimate makes it reasonably possible that actual adopt this accounting method because it requires the use of sub- results could materially differ from amounts estimated include: jective valuation models, which we believe are not representative self-insurance accruals; employee retirement plan obligations; of the real value of the options to either FedEx or our employees. If income tax liabilities; accounts receivable allowances; obso- compensation cost for stock-based compensation plans had been lescence of spare parts; airline stabilization compensation; determined under SFAS 123, pro forma net income, stock option contingent liabilities; and impairment assessments on long-lived compensation expense, and basic and diluted earnings per com- assets (including goodwill and indefinite lived intangible assets). mon share, assuming all options granted in 1996 and thereafter were valued at fair value using the Black-Scholes method, would NOTE 2: BUSINESS COMBINATIONS have been as follows (in millions, except per share amounts): On February 12, 2004, we acquired FedEx Kinko’s for approximately Years ended May 31, $2.4 billion in cash. We also assumed $39 million of capital lease 2004 2003 2002 obligations. FedEx Kinko’s is a leading provider of document solu- Net income, as reported $ 838 $ 830 $ 710 tions and business services. Its network of worldwide locations Add: Stock compensation included offers access to color printing, finishing and presentation services, in reported net income, net of tax 10 –– Internet access, videoconferencing, outsourcing, managed ser- Deduct: Total stock-based employee vices, Web-based printing and document management solutions. compensation expense determined under fair value based method The allocation of the purchase price to the fair value of the assets for all awards, net of tax benefit 37 34 37 acquired, liabilities assumed and goodwill, as well as the assign- Pro forma net income $ 811 $ 796 $ 673 ment of goodwill to our reportable segments, was based primarily Earnings per common share: on internal estimates of cash flows and independent appraisals. Basic – as reported $2.80 $ 2.79 $ 2.38 We used an independent appraisal firm to determine the fair Basic – pro forma $2.71 $ 2.67 $ 2.26 value of certain assets and liabilities, primarily property and equipment and acquired intangible assets, including: the value of Diluted – as reported $2.76 $ 2.74 $ 2.34 the Kinko’s trade name, customer-related intangibles, technology Diluted – pro forma $2.68 $ 2.63 $ 2.22

59 FEDEX CORPORATION

assets and contract-based intangibles. While the purchase price The following unaudited pro forma consolidated financial infor- allocation is substantially complete and we do not expect any mation presents the combined results of operations of FedEx and material adjustments, we may make adjustments to the purchase FedEx Kinko’s as if the acquisition had occurred at the beginning price allocation if new data becomes available. of 2003. The unaudited pro forma results have been prepared for comparative purposes only. Adjustments were made to the A significant amount of the purchase price was recorded as combined results of operations, primarily related to higher depre- goodwill, as the acquisition expands our portfolio of business ciation and amortization expense resulting from higher property services, while providing a substantially enhanced capability to and equipment values and acquired intangible assets and provide package-shipping services to small- and medium-sized additional interest expense resulting from acquisition debt. The business customers through FedEx Kinko’s array of retail store accounting literature establishes firm guidelines around how this locations. Because this was an acquisition of stock, goodwill is not pro forma information is presented, which precludes the assump- deductible for tax purposes. Approximately $200 million of the $1.7 tion of business synergies. Therefore, this unaudited pro forma billion goodwill balance will be attributed to the FedEx Express seg- information is not intended to represent, nor do we believe it is ment ($130 million) and the FedEx Ground segment ($70 million) indicative of the consolidated results of operations of FedEx that based on the expected increase in each segment’s incremental would have been reported had the acquisition been completed fair value as a result of the acquisition. as of the beginning of 2003. Furthermore, this pro forma informa- Our balance sheet reflects the following allocation of the total tion is not representative of the future consolidated results of purchase price of $2.4 billion (in millions): operations of FedEx. Current assets, primarily accounts Pro forma unaudited results were as follows (in millions, except receivable and inventory $ 236 per share data): Property and equipment 328 Years ended May 31, 2004 (1) 2003 Goodwill 1,739 Revenues $ 26,056 $24,427 Indefinite lived intangible asset (trade name) 567 Net income 836 841 Amortizable intangible assets 82 Basic earnings per common share 2.80 2.82 Other long-term assets 52 Diluted earnings per common share 2.75 2.78 Total assets acquired 3,004 Current liabilities (282) (1) Includes $27 million, net of tax, of nonrecurring expenses at FedEx Kinko’s, primarily in Deferred income taxes (266) anticipation of the acquisition. Also, includes $270 million, net of tax, of business realign- ment costs and a $37 million, net of tax, nonrecurring tax benefit at FedEx. Long-term capital lease obligations and other long-term liabilities (36) We paid a portion of the purchase price from available cash Total liabilities assumed (584) balances. To finance the remainder of the purchase price, we Total purchase price $ 2,420 entered into a six-month credit facility for $2 billion. During February 2004, we issued commercial paper backed by unused Indefinite lived intangible asset. This intangible asset represents commitments under this facility. In March 2004, we issued $1.6 the estimated fair value allocated to the Kinko’s trade name. billion of senior unsecured notes in three maturity tranches: one, This intangible asset will not be amortized because it has an three and five years at $600 million, $500 million and $500 million, indefinite remaining useful life based on the length of time that respectively. Net proceeds from the borrowings were used to the Kinko’s name had been in use, the Kinko’s brand awareness repay the commercial paper backed by the six-month credit facil- and market position and the plans for continued use of the ity. We canceled the six-month credit facility in March 2004. See Kinko’s brand. Note 6 for further discussion. Amortizable intangible assets. These intangible assets represent On March 1, 2002, a subsidiary of FedEx Trade Networks the value associated with business expected to be generated acquired for cash certain assets of Fritz Companies, Inc. that from existing customer relationships and contracts as of the provide essential customs clearance services exclusively for acquisition date. The value of these assets was primarily deter- FedEx Express in three U.S. locations, at a cost of $36.5 million. mined by measuring the present value of the projected future The excess cost over the estimated fair value of the net assets earnings attributable to these assets. Substantially all of these acquired (approximately $35 million) was recorded as goodwill, assets are being amortized on an accelerated basis over a which was entirely attributed to the FedEx Express segment. weighted-average estimated useful life of approximately seven Goodwill for tax purposes associated with this transaction will be years. While the useful life of these customer-relationship assets deductible over 15 years. Pro forma results including this acqui- is not limited by contract or any other economic, regulatory sition would not differ materially from reported results. or other known factors, the useful life of seven years was determined at the acquisition date based on management’s expectations of customer attrition patterns.

60 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

These acquisitions were accounted for under the purchase Amortization expense for intangible assets was $14 million in method of accounting. The operating results of the acquired busi- 2004, $13 million in 2003 and $14 million in 2002. Estimated amorti- nesses are included in our consolidated results of operations zation expense for the next five years is as follows (in millions): from the date of acquisition. 2005 $24 2006 23 NOTE 3: GOODWILL AND INTANGIBLES 2007 21 Effective June 1, 2001, we adopted SFAS 142, “Goodwill and Other 2008 20 Intangible Assets,” which establishes new accounting and 2009 17 reporting requirements for goodwill and other intangible assets. Under SFAS 142, material amounts of recorded goodwill attribut- NOTE 4: BUSINESS REALIGNMENT COSTS able to each of our reporting units were tested for impairment by During 2004, voluntary early retirement incentives with enhanced comparing the fair value of each reporting unit with its carrying pension and postretirement healthcare benefits were offered to value (including attributable goodwill). Fair value was determined certain groups of employees at FedEx Express who were age 50 using a discounted cash flow methodology. Based on our initial or older. Voluntary cash severance incentives were also offered impairment tests when the statement was adopted, we recog- to eligible employees at FedEx Express. These programs, which nized an adjustment of $25 million ($15 million or $0.05 per share, commenced August 1, 2003 and expired during the second quar- net of tax) in 2002 to reduce the carrying value of certain good- ter, were limited to eligible U.S. salaried staff employees and will. Under SFAS 142, the impairment adjustment recognized at managers. Approximately 3,600 employees accepted offers under adoption of the new rules was reflected as a cumulative effect of these voluntary programs, which considerably exceeded our accounting change in our 2002 consolidated statement of income. expectations. Costs were also incurred in 2004 for the elimination The carrying amount of goodwill attributable to each reportable of certain management positions at FedEx Express and other operating segment and changes therein follows (in millions): business units based on the staff reductions from the voluntary

Goodwill programs and other cost reduction initiatives. Acquired During May 31, 2003 the Year May 31, 2004 Costs for the benefits provided under the voluntary programs FedEx Express segment $ 397 $ 130 (1) $ 527 were recognized in the period that eligible employees accepted FedEx Ground segment –70(1) 70 the offer. Other costs associated with business realignment activ- FedEx Freight segment 666 – 666 ities were recognized in the period incurred. The savings from FedEx Kinko’s segment – 1,539 1,539 these initiatives will be reflected primarily in lower salaries and $1,063 $1,739 $2,802 benefits costs. (1) These amounts represent goodwill from the FedEx Kinko’s acquisition that is attributable The components of our business realignment costs and changes to the FedEx Express and FedEx Ground segments. in the related accruals were as follows for the year ended May 31, 2004 (in millions): The components of our intangible assets were as follows (in Voluntary Voluntary millions): Retirement Severance Other (1) Total May 31, 2004 May 31, 2003 Gross Carrying Accumulated Gross Carrying Accumulated Beginning accrual Amount Amortization Amount Amortization balances $– $ – $– $ – Amortizable Charged to expense 202 158 75 435 intangible assets Cash paid (8) (152) (31) (191) Customer relationships $ 72 $ (3) $– $– Amounts charged to Contract related 79 (43) 73 (37) other assets/liabilities (194) – (22) (216) Technology related Ending accrual balances $– $ 6 $22 $28

and other 45 (17) 40 (12) (1) Other includes costs for management severance agreements, which are payable Total $ 196 $ (63) $ 113 $ (49) over future periods, including compensation related to the modification of previously granted stock options and incremental pension and healthcare benefits. Other also Non-amortizing includes professional fees directly associated with the business realignment initiatives intangible asset and relocation costs. Trade name $ 567 $ – $– $– Amounts charged to other assets/liabilities relate primarily to incremental pension and healthcare benefits.

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NOTE 5: SELECTED CURRENT LIABILITIES The components of unsecured debt (net of discounts) were as follows (in millions): The components of selected current liability captions were as May 31, follows (in millions): 2004 2003 May 31, Senior unsecured debt 2004 2003 Interest rate of three-month LIBOR Accrued Salaries and Employee Benefits (1.11% at May 31, 2004) Salaries $ 163 $ 119 plus 0.28%, due in 2005 $ 600 $– Employee benefits 496 227 Interest rate of 7.80%, due in 2007 200 200 Compensated absences 403 378 Interest rate of 2.65%, due in 2007 500 – $1,062 $ 724 Interest rate of 3.50%, due in 2009 499 – Accrued Expenses Interest rates of 6.63% to 7.25%, Self-insurance accruals $ 442 $ 401 due through 2011 499 747 Taxes other than income taxes 291 279 Interest rate of 9.65%, due in 2013 299 299 Other 572 455 Interest rate of 7.60%, due in 2098 239 239 $1,305 $1,135 Medium term notes, interest rates of 8.00% to 10.57%, due through 2007 19 44 NOTE 6: LONG-TERM DEBT AND OTHER FINANCING $2,855 $1,529 ARRANGEMENTS The components of our long-term debt were as follows (in millions): To finance our acquisition of FedEx Kinko’s, we entered into a six-

May 31, month credit facility for $2 billion. During February 2004, we 2004 2003 issued commercial paper backed by unused commitments under Unsecured debt $2,855 $1,529 this facility. In March 2004, we issued $1.6 billion of senior unse- Capital lease obligations 534 422 cured notes in three maturity tranches: one, three and five years, Other debt, interest rates of 2.35% to 9.98% at $600 million, $500 million and $500 million, respectively. Net pro- due through 2017 198 66 ceeds from these borrowings were used to repay the commercial 3,587 2,017 paper backed by the six-month credit facility. We canceled the Less current portion 750 308 six-month credit facility in March 2004. $2,837 $1,709 In conjunction with the acquisition of FedEx Freight East in February 2001, debt of $240 million was assumed, a portion of At May 31, 2004, we had two revolving bank credit facilities total- which was refinanced subsequent to the acquisition. On April 5, ing $1 billion. One revolver provides for $750 million through 2002, we prepaid the remaining $101 million. Under the debt September 28, 2006. The second is a 364-day facility providing for agreements, we incurred a prepayment penalty of $13 million, $250 million through September 24, 2004. Interest rates on bor- which was included in other nonoperating expense in 2002. rowings under the agreements are generally determined by maturities selected and prevailing market conditions. Borrowings Capital lease obligations include certain special facility revenue under the credit agreements will bear interest, at our option, at a bonds that have been issued by municipalities primarily to finance rate per annum equal to either (a) the London Interbank Offered the acquisition and construction of various airport facilities and Rate (“LIBOR”) plus a credit spread, or (b) the higher of the equipment. These bonds require interest payments at least annu- Federal Funds Effective Rate, as defined, plus 1/2 of 1%, or the ally with principal payments due at the end of the related lease bank’s Prime Rate. The revolving credit agreements contain cer- agreements. In addition, during 2004, FedEx Express amended two tain covenants and restrictions, none of which are expected to leases for MD11 aircraft and during 2003, FedEx Express amended significantly affect our operations or ability to pay dividends. four leases for MD11 aircraft, which commit FedEx Express to firm purchase obligations for two of these aircraft during both 2005 From time to time, we finance certain operating and investing and 2006. These amended leases were accounted for as capital activities, including acquisitions, through the issuance of com- leases from the date of amendment. mercial paper. Our commercial paper program is backed by unused commitments under our revolving credit agreements and Other long-term debt includes $133 million related to two leased reduces the amounts available under the agreements. As of MD11 aircraft that are consolidated under the provisions of May 31, 2004 and 2003, no commercial paper borrowings were Financial Accounting Standards Board Interpretation No. (“FIN”) outstanding and the entire $1 billion under the revolving credit 46, “Consolidation of Variable Interest Entities, an Interpretation agreements was available. of ARB No. 51.” The debt requires interest at LIBOR plus a margin and is due in installments through March 30, 2007. See Note 16 for further discussion.

62 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

We incur other commercial commitments in the normal course of Rent expense under operating leases was as follows (in millions): business to support our operations. Letters of credit at May 31, For years ended May 31, 2004 were $498 million. The amount unused under our letter of 2004 2003 2002 credit facility totaled $114 million at May 31, 2004. This facility Minimum rentals $1,560 $1,522 $1,453 expires in May of 2006. These instruments are generally required Contingent rentals 143 107 132 under certain U.S. self-insurance programs and are used in the $1,703 $1,629 $1,585 normal course of international operations. The underlying liabili- ties insured by these instruments are reflected in the balance Contingent rentals are based on equipment usage. sheet, where applicable. Therefore, no additional liability is A summary of future minimum lease payments under capital reflected for the letters of credit. leases and noncancelable operating leases (principally aircraft, Scheduled annual principal maturities of debt, exclusive of capital retail locations and facilities) with an initial or remaining term in leases, for the five years subsequent to May 31, 2004, are as excess of one year at May 31, 2004 is as follows (in millions): follows (in millions): Capital Operating Leases Leases 2005 $613 2005 $160 $ 1,707 2006 265 2006 122 1,555 2007 844 2007 22 1,436 2008 – 2008 99 1,329 2009 499 2009 11 1,169 Long-term debt, exclusive of capital leases, had carrying values Thereafter 225 7,820 of $3.0 billion and $1.6 billion at May 31, 2004 and 2003, respectively, 639 $15,016 compared with estimated fair values of approximately $3.2 billion Less amount representing interest 105 and $1.9 billion at those respective dates. The estimated fair val- Present value of net minimum lease payments $534 ues were determined based on quoted market prices or on the FedEx Express makes payments under certain leveraged operat- current rates offered for debt with similar terms and maturities. ing leases that are sufficient to pay principal and interest on We have a $1.0 billion shelf registration statement with the SEC to certain pass-through certificates. The pass-through certificates provide flexibility and efficiency when obtaining financing. Under are not direct obligations of, or guaranteed by, FedEx or FedEx this shelf registration statement we may issue, in one or more Express. offerings, either unsecured debt securities, common stock or a combination of such instruments. The entire $1 billion is available NOTE 8: PREFERRED STOCK for future financings. Our Certificate of Incorporation authorizes the Board of Directors, at its discretion, to issue up to 4,000,000 shares of series preferred NOTE 7: LEASE COMMITMENTS stock. The stock is issuable in series, which may vary as to cer- We utilize certain aircraft, land, facilities, retail locations and tain rights and preferences, and has no par value. As of May 31, equipment under capital and operating leases that expire at var- 2004, none of these shares had been issued. ious dates through 2039. In addition, supplemental aircraft are leased under agreements that generally provide for cancelation NOTE 9: COMMON STOCKHOLDERS’ INVESTMENT upon 30 days’ notice. TREASURY SHARES The following table summarizes information about treasury share The components of property and equipment recorded under cap- repurchases for the years ended May 31: ital leases were as follows (in millions): May 31, 2004 2003 2002 2004 2003 Average Average Average Aircraft $344 $221 Price Price Price Shares Per Share Shares Per Share Shares Per Share Package handling and ground support Repurchased 2,625,000 $68.14 3,275,000 $56.66 3,350,000 $52.70 equipment and vehicles 207 207 Other, principally facilities 230 137 These repurchases were done under share repurchase programs 781 565 aggregating 15 million shares. A total of 5.75 million shares Less accumulated amortization 390 268 remain under existing share repurchase authorizations. At $391 $297 May 31, 2004 and 2003, respectively, 4,760 and 406,304 shares remained outstanding in treasury.

63 FEDEX CORPORATION

STOCK COMPENSATION PLANS Expected Lives. This is the period of time over which the options Fixed Stock Option Plans granted are expected to remain outstanding. Generally, options Under the provisions of our stock incentive plans, key employees granted have a maximum term of 10 years. We examine actual and non-employee directors may be granted options to purchase stock option exercises to determine the expected life of the shares of common stock at a price not less than its fair market options. An increase in the expected term will increase compen- value at the date of grant. Options granted have a maximum term of sation expense. 10 years. Vesting requirements are determined at the discretion of Expected Volatility. Actual changes in the market value of our the Compensation Committee of our Board of Directors. Option- stock are used to calculate the volatility assumption. We calcu- vesting periods range from one to four years with more than 80% late daily market value changes from the date of grant over a past of stock option grants vesting ratably over four years. At May 31, period equal to the expected life of the options to determine 2004, there were 4,140,440 shares available for future grants volatility. An increase in the expected volatility will increase com- under these plans. pensation expense. The weighted-average fair value of these grants, calculated Risk-Free Interest Rate. This is the U.S. Treasury Strip rate posted using the Black-Scholes valuation method under the assumptions at the date of grant having a term equal to the expected life of the indicated below, was $18.02, $17.12 and $12.39 per option in 2004, option. An increase in the risk-free interest rate will increase 2003 and 2002, respectively. compensation expense. We are required to disclose the pro forma effect of accounting Dividend Yield. This is the annual rate of dividends per share over for stock options using such a valuation method for all options the exercise price of the option. In July 2002, we paid the first granted in 1996 and thereafter (see Note 1). We use the Black- dividend in the history of the company. Therefore, the fair value Scholes option-pricing model to calculate the fair value of options of options prior to 2003 is not affected by the dividend yield. for our pro forma disclosures. The key assumptions for this valu- An increase in the dividend yield will decrease compensation ation method include the expected life of the option, stock price expense. volatility, risk-free interest rate, dividend yield, forfeiture rate and exercise price. Many of these assumptions are judgmental and Forfeiture Rate. This is the estimated percentage of options highly sensitive in the determination of pro forma compensation granted that are expected to be forfeited or canceled before expense. Following is a table of the key weighted-average becoming fully vested. This percentage is derived from historical assumptions used in the option valuation calculations for the experience. An increase in the forfeiture rate will decrease com- options granted in the years ended May 31, 2004, 2003 and 2002, pensation expense. Our forfeiture rate is approximately 8%. and a discussion of our methodology for developing each of the assumptions used in the valuation model:

May 31, 2004 2003 2002 Expected lives 4 years 4 years 4 years Expected volatility 32% 35% 30% Risk-free interest rate 2.118% 4.017% 4.777% Dividend yield 0.3102% 0.3785% 0%

64 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes information about our fixed stock option plans for the years ended May 31:

2004 2003 2002 Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price Outstanding at beginning of year 17,315,116 $38.88 17,306,014 $34.32 17,498,558 $30.24 Granted 3,937,628 64.96 3,261,800 53.22 4,023,098 40.66 Exercised (3,724,605) 31.05 (2,951,154) 27.73 (3,875,767) 22.34 Forfeited (178,832) 46.71 (301,544) 40.47 (339,875) 35.06 Outstanding at end of year 17,349,307 46.39 17,315,116 38.88 17,306,014 34.32 Exercisable at end of year 8,747,523 38.28 8,829,515 33.58 8,050,362 29.98

The following table summarizes information about fixed stock options outstanding at May 31, 2004:

Options Outstanding Options Exercisable Weighted- Weighted- Weighted- Average Average Average Range of Number Remaining Exercise Number Exercise Exercise Price Outstanding Contractual Life Price Exercisable Price $14.59 – $21.89 970,670 1.9 years $19.15 970,670 $19.15 21.97 – 32.95 2,500,525 3.7 years 29.71 2,437,553 29.86 33.02 – 49.52 5,635,270 6.6 years 39.58 3,248,939 39.49 49.71 – 73.67 8,242,842 8.0 years 59.31 2,090,361 55.09 14.59 – 73.67 17,349,307 6.6 years 46.39 8,747,523 38.28

Total equity compensation shares outstanding or available for grant represented approximately 7.1% and 7.3% of total outstanding com- mon and equity compensation shares and equity compensation shares available for grant at May 31, 2004 and May 31, 2003, respectively. Stock Options Expensed Under our business realignment programs discussed in Note 4, we recognized approximately $16 million of expense ($10 million, net of tax) during 2004 related to the modification of previously granted stock options. We calculated this expense using the Black-Scholes method. Restricted Stock Plans Under the terms of our restricted stock plans, shares of common stock are awarded to key employees. All restrictions on the shares expire ratably over a four-year period. Shares are valued at the market price at the date of award. Compensation related to these plans is recorded as a reduction of common stockholders’ investment and is amortized to expense as restrictions on such shares expire. The following table summarizes information about restricted stock awards for the years ended May 31:

2004 2003 2002 Weighted- Weighted- Weighted- Average Average Average Shares Fair Value Shares Fair Value Shares Fair Value Awarded 282,423 $67.11 343,500 $47.56 329,500 $43.01 Forfeited 10,000 43.41 17,438 48.01 12,000 49.79

At May 31, 2004, there were 747,553 shares available for future awards under these plans. Annual compensation cost for the restricted stock plans was approximately $14 million for 2004, and $12 million for 2003 and 2002.

65 FEDEX CORPORATION

NOTE 10: COMPUTATION OF EARNINGS PER SHARE The lower effective tax rate in 2004 was primarily attributable to the favorable decision in our U.S. tax case described below, The calculation of basic earnings per common share and diluted stronger than anticipated international results and the results of earnings per common share for the years ended May 31 was as tax audits during 2004. Our stronger than anticipated international follows (in millions, except per share amounts): results, along with other factors, increased our ability to credit 2004 2003 2002 income taxes paid to foreign governments on foreign income Net income applicable to against U.S. income taxes paid on the same income, thereby mit- common stockholders $ 838 $ 830 $ 710 igating our exposure to double taxation. The 38.0% effective tax Weighted-average shares of rate in 2003 was higher than the 2002 rate primarily due to lower common stock outstanding 299 298 298 state taxes in 2002. Common equivalent shares: Assumed exercise of The significant components of deferred tax assets and liabilities outstanding dilutive options 19 15 16 as of May 31 were as follows (in millions): Less shares repurchased from 2004 2003 Deferred Deferred Deferred Deferred proceeds of assumed Tax Assets Tax Liabilities Tax Assets Tax Liabilities exercise of options (14) (10) (11) Property, equipment, Weighted-average common leases and intangibles $ 310 $1,372 $ 303 $ 946 and common equivalent Employee benefits 386 406 270 407 shares outstanding 304 303 303 Self-insurance accruals 297 – 259 – Basic earnings Other 277 179 261 207 per common share $2.80 $ 2.79 $2.38 Net operating loss/credit Diluted earnings carryforwards 32 – 15 – per common share $2.76 $ 2.74 $2.34 Valuation allowance (37) – (14) – $1,265 $1,957 $1,094 $1,560 NOTE 11: INCOME TAXES In 2004, the net deferred tax liability of $692 million is classified in The components of the provision for income taxes for the years the balance sheet as a current deferred tax asset of $489 million ended May 31 were as follows (in millions): and a noncurrent deferred tax liability of $1.181 billion. In 2003, 2004 2003 2002 the net deferred tax liability of $466 million is classified in the bal- Current provision ance sheet as a current deferred tax asset of $416 million and a Domestic: noncurrent deferred tax liability of $882 million. Federal $ 371 $112 $ 255 The valuation allowance primarily represents amounts reserved State and local 54 28 39 for operating loss and tax credit carryforwards, which expire over Foreign 85 39 41 varying periods starting in 2005. As a result of this and other fac- 510 179 335 tors, we believe that a substantial portion of these deferred tax Deferred (benefit) provision assets may not be realized. The net increase in the valuation Domestic: allowance of $23 million was principally due to net operating Federal (22) 304 99 loss/credit carryforwards obtained upon the acquisition of FedEx State and local (7) 25 3 Kinko’s during the third quarter of 2004 that are not expected to Foreign – – (2) be realized. (29) 329 100 $ 481 $508 $ 435 In August 2003, we received a favorable ruling from the U.S. District Court in Memphis over the tax treatment of jet engine A reconciliation of the statutory federal income tax rate to the effec- maintenance costs. The Court held that these costs were ordi- tive income tax rate for the years ended May 31 was as follows: nary and necessary business expenses and properly deductible 2004 2003 2002 by us. In connection with an Internal Revenue Service (“IRS”) Statutory U.S. income tax rate 35.0% 35.0% 35.0% audit for the tax years 1993 and 1994, the IRS had proposed Increase resulting from: adjustments characterizing routine jet engine maintenance costs State and local income taxes, as capital expenditures that must be recovered over seven years, net of federal benefit 2.3 2.6 2.4 rather than as expenses that are deducted immediately, as has Other, net (0.8) 0.4 0.1 been our practice. After settlement discussions failed to resolve Effective tax rate 36.5% 38.0% 37.5% this matter, in 2001 we paid $70 million in tax and interest and filed suit in Federal District Court for a complete refund of the amounts

66 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

paid plus interest. Although the IRS has continued to assert its investment return that meets our pension plan obligations. Active position in audits for the years 1995 through 2000 with respect to management strategies are utilized within the plan in an effort to maintenance costs for jet engines and rotable aircraft parts, we realize investment returns in excess of market indices. believe this ruling should also apply to future tax years. Our pension cost is materially affected by the discount rate used As a result of this ruling, we recognized a one-time benefit in 2004 to measure pension obligations, the level of plan assets available of $26 million, net of tax, primarily related to the reduction of to fund those obligations at the measurement date and the accruals related to this matter and the recognition of interest expected long-term rate of return on plan assets. Due to a lower earned on the amount we paid in 2001. These adjustments affected discount rate, a lower expected long-term rate of return and a both net interest expense ($30 million pretax) and income tax reduction in the value of plan assets as a result of invest- expense ($7 million). Future periods are not expected to be mate- ment losses at the measurement date for 2004 pension expense rially affected by the resolution of this matter. On November 19, (February 28, 2003), our total net pension cost for 2004 increased 2003, the IRS appealed this ruling to the Sixth Circuit Court of by approximately $115 million. Appeals. All briefs have been filed in the case. We believe the An increase in pension cost of approximately $30 million is District Court’s ruling will be upheld on appeal. expected for 2005 based primarily on a continuing decline in the discount rate (to 6.78%). Management reviews the assumptions NOTE 12: EMPLOYEE BENEFIT PLANS used to measure pension costs (including the discount rate and Pension Plans the expected long-term rate of return on pension assets) on an We sponsor defined benefit pension plans covering a majority of annual basis. Economic and market conditions at the measure- our employees. The largest plan covers certain U.S. employees ment date impact these assumptions from year to year and it is age 21 and over, with at least one year of service. Eligible employ- reasonably possible that material changes in pension cost may ees as of May 31, 2003 were given the opportunity to make a continue to be experienced in the future. one-time election to accrue future pension benefits under either Establishing the expected future rate of investment return on our a new cash balance formula which we call the Portable Pension pension assets is a judgmental matter. Management considers Account or a traditional pension benefit formula. Benefits pro- the following factors in determining this assumption: vided under the traditional formula are based on average earnings and years of service. Under the Portable Pension • the duration of our pension plan liabilities, which drives the Account, the retirement benefit is expressed as a dollar amount investment strategy we can employ with our pension plan assets. in a notional account that grows with annual credits based on • the types of investment classes in which we invest our pension pay, age, and years of credited service, and interest on the notional plan assets and the expected compound return we can reason- account balance. In either case, employees retained all benefits ably expect those investment classes to earn over the next previously accrued under the traditional pension benefit formula 10- to 15-year time period (or such other time period that may and continue to receive the benefit of future salary increases on be appropriate). benefits accrued as of May 31, 2003. Eligible employees hired after May 31, 2003 receive benefits exclusively under the Portable • the investment returns we can reasonably expect our active Pension Account. investment management program to achieve in excess of the returns we could expect if investments were made strictly in Plan funding is actuarially determined and is subject to certain indexed funds. tax law limitations. International defined benefit pension plans provide benefits primarily based on final earnings and years of We review the expected long-term rate of return on an annual service and are funded in accordance with local laws and basis and revise it as appropriate. Also, we periodically commis- income tax regulations. Substantially all plan assets are actively sion detailed asset/liability studies performed by third-party managed. The weighted-average asset allocation for our primary professional investment advisors and actuaries. These studies pension plan at February 29, 2004 was as follows: project our estimated future pension payments and evaluate the

Actual Target efficiency of the allocation of our pension plan assets into various Domestic equities 54% 53% investment categories. These studies also generate probability- International equities 19 17 adjusted expected future returns on those assets. The study Private equities 35performed for 2003 supported the reasonableness of our 10.10% Long duration fixed income securities 16 15 return assumption used for 2003 based on our liability duration and Other fixed income securities 810market conditions at the time we set this assumption (in 2002). We 100% 100% performed a more recent asset/liability study for 2004, which sup- ported a long-term return on assets of 9.10%. The results of this The investment strategy for pension plan assets is to utilize a diver- study were reaffirmed for 2005 by our third-party professional sified mix of global public and private equity portfolios, together investment advisors and actuaries. with public and private fixed income portfolios, to earn a long-term

67 FEDEX CORPORATION

Postretirement Healthcare Plans Certain of our subsidiaries offer medical, dental and vision coverage to eligible U.S. retirees and their eligible dependents. U.S. employ- ees covered by the principal plan become eligible for these benefits at age 55 and older, if they have permanent, continuous service of at least 10 years after attainment of age 45 if hired prior to January 1, 1988, or at least 20 years after attainment of age 35 if hired on or after January 1, 1988. The following table provides a reconciliation of the changes in the pension and postretirement healthcare plans’ benefit obligations and fair value of assets over the two-year period ended May 31, 2004 and a statement of the funded status as of May 31, 2004 and 2003 (in millions):

Postretirement Pension Plans Healthcare Plans 2004 2003 2004 2003 Changes in Projected Benefit Obligation (“PBO”) Projected benefit obligation at the beginning of year $ 7,117 $ 6,227 $382 $ 329 Service cost 376 374 35 27 Interest cost 490 438 25 25 Actuarial loss 661 164 36 23 Benefits paid (136) (103) (23) (21) Special termination benefits (1) 158 – 38 – Amendments, benefit enhancements and other 17 17 3 (1) Projected benefit obligation at the end of year $ 8,683 $ 7,117 $496 $382 Accumulated Benefit Obligation (“ABO”) $ 7,427 $ 6,009 Change in Plan Assets Fair value of plan assets at beginning of year $ 5,825 $ 5,510 $– $– Actual return (loss) on plan assets 1,751 (663) – – Company contributions 335 1,072 16 18 Benefits paid (136) (103) (23) (21) Other 8 9 7 3 Fair value of plan assets at end of year $ 7,783 $ 5,825 $– $– Funded Status of the Plans $ (900) $ (1,292) $ (496) $ (382) Unrecognized actuarial loss (gain) 1,694 2,247 (1) (38) Unamortized prior service cost (benefit) 118 123 1 (1) Unrecognized transition amount (5) (7) – – Prepaid (accrued) benefit cost $ 907 $ 1,071 $ (496) $ (421) Amount Recognized in the Balance Sheet at May 31: Prepaid benefit cost $ 1,127 $ 1,269 $– $– Accrued benefit liability (220) (198) (496) (421) Minimum pension liability (67) (42) – – Accumulated other comprehensive income (2) 54 26 – – Intangible asset 13 16 – – Prepaid (accrued) benefit cost $ 907 $ 1,071 $ (496) $ (421)

(1) The special termination benefits reflected in the table above related primarily to early retirement incentives offered to certain groups of our employees at FedEx Express during 2004 (see Note 4 for more information). (2) The minimum pension liability component of Accumulated Other Comprehensive Income is shown in the Statement of Changes in Stockholders’ Investment and Comprehensive Income, net of deferred taxes.

68 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Our pension plans included the following components at May 31, 2004 and 2003 (in millions):

U.S. Plans Qualified Nonqualified International Plans Total 2004 2003 2004 2003 2004 2003 2004 2003 ABO $ 7,069 $ 5,725 $ 166 $ 130 $ 192 $ 154 $ 7,427 $ 6,009 PBO $ 8,274 $ 6,793 $ 179 $ 144 $ 230 $ 180 $ 8,683 $ 7,117 Fair Value of Plan Assets 7,678 5,747 – – 105 78 7,783 5,825 Funded Status $ (596) $ (1,046) $ (179) $ (144) $ (125) $ (102) $ (900) $ (1,292) Unrecognized actuarial loss 1,621 2,208 32 5 41 34 1,694 2,247 Unamortized prior service cost 95 105 20 18 3 – 118 123 Unrecognized transition amount (7) (8) – – 2 1 (5) (7) Prepaid (accrued) benefit cost $ 1,113 $ 1,259 $ (127) $ (121) $ (79) $(67) $907 $ 1,071

The projected benefit obligation (“PBO”) is the actuarial present we made $320 million in tax-deductible contributions. No contri- value of benefits attributable to employee service rendered to butions for 2004 or 2003 were legally required and none are date, including the effects of estimated future pay increases. The expected to be required in 2005. Based on the substantial accumulated benefit obligation (“ABO”) also reflects the actuarial improvement in the funded status of our qualified plans, we do present value of benefits attributable to employee service ren- not currently expect to contribute any funds to our qualified dered to date, but does not include the effects of estimated future defined benefit plans in 2005. pay increases. Therefore, the ABO as compared to plan assets is We have certain nonqualified defined benefit pension plans that an indication of the assets currently available to fund vested and are not funded because such funding would be deemed current nonvested benefits accrued through May 31. compensation to plan participants. Primarily related to those The measure of whether a pension plan is underfunded for finan- plans and certain international plans, we have ABOs aggregating cial accounting purposes is based on a comparison of the ABO to approximately $356 million at May 31, 2004 and $284 million at the fair value of plan assets and amounts accrued for such bene- May 31, 2003, with assets of $105 million at May 31, 2004 and $78 fits in the balance sheet. In order to eliminate the need to million at May 31, 2003. Plans with this funded status resulted in recognize an additional minimum pension liability (generally the recognition of a minimum pension liability in our balance required when the ABO exceeds the fair value of plan assets at sheets. This minimum liability was $67 million at May 31, 2004 and the measurement date), we made $1.1 billion of tax-deductible $42 million at May 31, 2003. contributions to our qualified U.S. pension plans in 2003. In 2004,

69 FEDEX CORPORATION

Net periodic benefit cost for the three years ended May 31 was as follows (in millions):

Pension Plans Postretirement Healthcare Plans 2004 2003 2002 2004 2003 2002 Service cost $ 376 $ 374 $ 348 $35 $27 $27 Interest cost 490 438 409 25 25 25 Expected return on plan assets (597) (594) (621) – – – Net amortization and deferral 74 10 13 – (2) (2) $ 343 $ 228 $ 149 $60 $50 $50

Weighted-average actuarial assumptions for our primary U.S. plans, which comprise substantially all of our projected benefit obliga- tions, were as follows: Pension Plans Postretirement Healthcare Plans 2004 2003 2002 2004 2003 2002 Discount rate 6.78% 6.99% 7.11% 6.57% 6.75% 7.30% Rate of increase in future compensation levels 3.15 3.15 3.25 – – – Expected long-term rate of return on assets 9.10* 10.10 10.90 – – –

*For 2005, the expected long-term rate of return on plan assets will continue to be 9.10%.

The expected long-term rate of return assumptions for each for discretionary employer contributions, which are determined asset class are selected based on historical relationships annually by our Board of Directors. Other plans provide match- between the assets classes and the economic and capital market ing funds based on employee contributions to 401(k) plans. environments, updated for current conditions. Expense under these plans was $89 million in 2004, $82 million in 2003 and $75 million in 2002. Benefit payments, which reflect expected future service, as appropriate, are expected to be paid as follows for the years end- NOTE 13: BUSINESS SEGMENT INFORMATION ing May 31 (in millions):

Pension Benefits Our operations for the periods presented are primarily represent- 2005 $ 216 ed by FedEx Express, FedEx Ground, FedEx Freight and FedEx 2006 219 Kinko’s. These businesses form the core of our reportable seg- 2007 257 ments. Other business units in the FedEx portfolio are FedEx Trade 2008 283 Networks, FedEx Supply Chain Services, FedEx Custom Critical 2009 319 and Caribbean Transportation Services. Management evaluates 2010-2014 2,389 segment financial performance based on operating income. In 2004, we changed the reporting and responsibility relationships of These estimates are based on assumptions about future events. our smaller business units so that they now report directly to a core Actual benefit payments may vary significantly from these estimates. segment. Prior year amounts have been reclassified to conform to Future medical benefit costs are estimated to increase at an the new segment presentation. As a result, our reportable seg- annual rate of 14% during 2005, decreasing to an annual growth ments included the following businesses for the periods presented: rate of 5% in 2019 and thereafter. Future dental benefit costs are FedEx Express Segment FedEx Express estimated to increase at an annual rate of 7% during 2005, FedEx Trade Networks decreasing to an annual growth rate of 5% in 2013 and thereafter. Our postretirement healthcare cost is capped at 150% of the 1993 FedEx Ground Segment FedEx Ground employer cost and, therefore, is not subject to medical and dental FedEx Supply Chain Services trends after the capped cost is attained. Therefore, a 1% change FedEx Freight Segment FedEx Freight in these annual trend rates would not have a significant impact FedEx Custom Critical on the accumulated postretirement benefit obligation at May 31, Caribbean Transportation 2004, or 2004 benefit expense. Services Defined Contribution Plans FedEx Kinko’s Segment FedEx Kinko’s Profit sharing and other defined contribution plans are in place covering a majority of U.S. employees. Profit sharing plans provide

70 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table provides a reconciliation of reportable segment revenues, depreciation and amortization, operating income (loss) and segment assets to consolidated financial statement totals for the years ended or as of May 31 (in millions):

FedEx FedEx FedEx FedEx Express Ground Freight Kinko’s Other and Consolidated Segment Segment Segment Segment (1) Eliminations (2) Total Revenues 2004 $17,497 $ 3,910 $ 2,689 $ 521 $ 93 $ 24,710 2003 16,467 3,581 2,443 – (4) 22,487 2002 15,438 2,918 2,253 – (2) 20,607 Depreciation and amortization 2004 $ 810 $ 154 $ 92 $ 33 $ 286 $ 1,375 2003 818 155 88 – 290 1,351 2002 819 136 91 – 318 1,364 Operating income (loss) (3) 2004 $ 629 $ 522 $ 244 $ 39 $ 6 $ 1,440 2003 783 494 193 – 1 1,471 2002 801 337 185 – (2) 1,321 Segment assets (4) 2004 $12,443 $ 2,248 $ 1,924 $2,903 $(384) $ 19,134 2003 11,188 1,846 1,825 – 526 15,385 2002 10,151 1,480 1,786 – 395 13,812

(1) Includes the operations of FedEx Kinko’s from the formation of the FedEx Kinko’s segment on March 1, 2004. (2) Includes the results of operations of FedEx Kinko’s from February 12, 2004 (date of acquisition) through February 29, 2004 (approximately $100 million of revenue and $6 million of operating income). (3) Includes business realignment costs of $428 million in the FedEx Express segment, $1 million in the FedEx Ground segment and $6 million in Other and Eliminations. (4) Segment assets include intercompany receivables.

The following table provides a reconciliation of reportable segment capital expenditures to consolidated totals for the years ended May 31 (in millions): FedEx FedEx FedEx FedEx Express Ground Freight Kinko’s Consolidated Segment Segment Segment Segment Other Total 2004 $ 592 $314 $130 $36 $199 $1,271 2003 917 252 139 – 203 1,511 2002 1,069 214 86 – 246 1,615

71 FEDEX CORPORATION

The following table presents revenue by service type and geo- NOTE 14: SUPPLEMENTAL CASH FLOW INFORMATION graphic information for the years ended or as of May 31 (in Cash paid for interest expense and income taxes for the years millions): ended May 31 was as follows (in millions):

Revenue by Service Type 2004 2003 2002 2004 2003 2002 Interest (net of capitalized interest) $151 $125 $146 FedEx Express segment: Income taxes 364 53 312 Package: U.S. overnight box $ 5,558 $ 5,432 $ 5,338 FedEx Express amended two leases in 2004 and four leases in U.S. overnight envelope 1,700 1,715 1,755 2003 for MD11 aircraft, which required FedEx Express to record U.S. deferred 2,592 2,510 2,383 $110 million in 2004 and $221 million in 2003, in both fixed assets Total domestic package and long-term liabilities. revenue 9,850 9,657 9,476 International priority 5,131 4,367 3,834 FedEx Express consolidated an entity that owns two MD11 aircraft Total package revenue 14,981 14,024 13,310 under the provisions of FIN 46. The consolidation of this entity on Freight: September 1, 2003 resulted in an increase in our fixed assets and U.S. 1,609 1,564 1,273 long-term liabilities of approximately $140 million. See Note 16. International 393 400 384 Total freight revenue 2,002 1,964 1,657 NOTE 15: GUARANTEES AND INDEMNIFICATIONS Other 514 479 471 We adopted FIN 45, “Guarantor’s Accounting and Disclosure Total FedEx Express segment 17,497 16,467 15,438 Requirements for Guarantees, Including Indirect Guarantees FedEx Ground segment 3,910 3,581 2,918 of Indebtedness of Others,” during 2003, which required the FedEx Freight segment 2,689 2,443 2,253 prospective recognition and measurement of certain guarantees FedEx Kinko’s segment (1) 521 – – and indemnifications. Accordingly, any contractual guarantees or Other and Eliminations (2) 93 (4) (2) indemnifications we have issued or modified subsequent to $ 24,710 $ 22,487 $20,607 December 31, 2002 are subject to evaluation. If required, a liability Geographical Information(3) for the fair value of the obligation undertaken will be recognized. Revenues: Substantially all of our guarantees and indemnifications were U.S. $18,643 $ 17,277 $15,968 entered into prior to December 31, 2002 and have not been modi- International 6,067 5,210 4,639 fied since then. Therefore, no amounts have been recognized in $ 24,710 $ 22,487 $20,607 our financial statements for the underlying fair value of these Noncurrent assets: obligations. With the exception of residual value guarantees in U.S. $12,644 $ 9,908 $ 8,627 certain operating leases, a maximum obligation is generally not International 1,520 1,536 1,520 specified in our guarantees and indemnifications. As a result, the $ 14,164 $ 11,444 $10,147 overall maximum potential amount of the obligation under such (1) Includes the operations of FedEx Kinko’s from the formation of the FedEx Kinko’s guarantees and indemnifications cannot be reasonably estimated. segment on March 1, 2004. (2) Includes the results of operations of FedEx Kinko’s from February 12, 2004 (date of Historically, we have not been required to make significant pay- acquisition) through February 29, 2004 (approximately $100 million of revenue). ments under our guarantee or indemnification obligations. (3) International revenue includes shipments that either originate in or are destined to locations outside the United States. Noncurrent assets include property and equipment, Operating Leases goodwill and other long-term assets. Flight equipment is allocated between geographic We have guarantees under certain operating leases, amounting areas based on usage. to $43 million as of May 31, 2004, for the residual values of vehi- cles and facilities at the end of the respective operating lease periods. Under these leases, if the fair market value of the leased asset at the end of the lease term is less than an agreed-upon value as set forth in the related operating lease agreement, we will be responsible to the lessor for the amount of such deficiency. Based upon our expectation that none of these leased assets will have a residual value at the end of the lease term that is materi- ally less than the value specified in the related operating lease agreement, we do not believe it is probable that we will be required to fund any amounts under the terms of these guarantee arrangements. Accordingly, no accruals have been recognized for these guarantees.

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Certain of our operating leases contain other indemnification was $89 million. FIN 46 required us to consolidate the separate obligations to the lessor, which are considered ordinary and cus- entity that owns the two MD11 aircraft. Since the entity was cre- tomary (e.g., use and environmental indemnifications). The terms ated before February 1, 2003, we measured the assets and of these obligations range in duration and often are not limited. liabilities at their carrying amounts (the amounts at which they Such indemnification obligations continue until and, in many would have been recorded in the consolidated financial state- cases, after expiration of the respective lease. ments if FIN 46 had been effective at the inception of the lease). As a result of this consolidation, the accompanying May 31, 2004 Other Contracts balance sheet includes an additional $126 million of fixed assets In conjunction with certain transactions, primarily sales or pur- and $133 million of long-term liabilities. chases of operating assets or services in the ordinary course of business, we sometimes provide routine indemnifications (e.g., NOTE 17: COMMITMENTS environmental, tax and software infringement), the terms of which range in duration and often are not limited. Annual purchase commitments under various contracts as of May 31, 2004 were as follows (in millions): Intra-company Guarantees FedEx’s publicly held debt (approximately $2.3 billion) is guar- Aircraft- Aircraft Related (1) Other (2) Total anteed by our subsidiaries. The guarantees are full and uncon- 2005 $ 22 $ 170 $409 $ 601 ditional, joint and several and any subsidiaries that are not 2006 – 136 119 255 guarantors are minor as defined by Securities and Exchange 2007 111 97 44 252 Commission regulations. FedEx, as the parent company issuer of 2008 131 67 14 212 this debt, has no independent assets or operations. There are no 2009 567 63 13 643 significant restrictions on our ability or the ability of any guaran- Thereafter 1,141 119 179 1,439 tor to obtain funds from its subsidiaries by such means as a dividend or loan. (1) Primarily aircraft modifications. (2) Primarily vehicles, facilities, computers, printing and other equipment and advertising Special facility revenue bonds have been issued by certain munic- and promotions contracts. ipalities primarily to finance the acquisition and construction of various airport facilities and equipment. In certain cases, the bond The amounts reflected in the table above for purchase commit- proceeds were loaned to FedEx Express and are included in long- ments represent noncancelable agreements to purchase goods term debt and, in other cases, the facilities were leased to us and or services. Such contracts include those for certain purchases are accounted for as either capital leases or operating leases. of aircraft, aircraft modifications, vehicles, facilities, computers, Approximately $800 million in principal of these bonds (with total printing and other equipment and advertising and promotions future principal and interest payments of approximately $1.5 bil- contracts. Open purchase orders that are cancelable are not lion as of May 31, 2004) is unconditionally guaranteed by FedEx considered unconditional purchase obligations for financial Express. Of the $800 million bond principal, $45 million was in long- reporting purposes. term debt and $204 million was in capital lease obligations at May FedEx Express is committed to purchase two A310s, seven ATRs 31, 2004 and the remainder was in operating leases. and ten Airbus A380s (a new high-capacity, long-range aircraft). The A310s and ATRs are expected to be delivered in 2005. FedEx NOTE 16: VARIABLE INTEREST ENTITIES Express expects to take delivery of three of the ten A380 aircraft FedEx Express entered into a lease in July 2001 for two MD11 air- in each of 2009, 2010 and 2011 and the remaining one in 2012. craft. These assets are held by a separate entity, which was Deposits and progress payments of $25 million have been made established and is owned by independent third parties who pro- toward these purchases and other planned aircraft-related vide financing through debt and equity participation. The original transactions. In addition, we have committed to modify our DC10 cost of the assets under the lease was approximately $150 million. aircraft for passenger-to-freighter and two-man cockpit config- urations. Payments related to these activities are included in the This lease contains residual value guarantees that obligate FedEx table above. Aircraft and aircraft-related contracts are subject to Express, not the third-party owners, to absorb the majority of the price escalations. losses, if any, of the entity. The lease also provides FedEx Express with the right to receive any residual returns of the entity if they occur. At May 31, 2004, the residual value guarantee associated with this lease, which represents the maximum exposure to loss,

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NOTE 18: LEGAL PROCEEDINGS In the opinion of management, the aggregate liability, if any, with respect to these claims will not materially adversely affect our Operations in 2002 were significantly affected by the terrorist financial position, results of operations or cash flows. attacks on September 11, 2001. During 2002, we recognized a total of $119 million of compensation under the Air Transportation Also, see Note 11 for discussion of other legal proceedings. Safety and System Stabilization Act (the “Act”), of which $101 FedEx and its subsidiaries are subject to other legal proceedings million had been received as of May 31, 2004. The amounts recog- that arise in the ordinary course of their business. In the opinion nized were for our estimate of losses we incurred as a result of the of management, the aggregate liability, if any, with respect to mandatory grounding of our aircraft and for incremental losses these other actions will not materially adversely affect our finan- incurred through December 31, 2001. All amounts recognized cial position, results of operations or cash flows. were reflected as reduction of operating expense under the cap- tion “Airline stabilization compensation.” NOTE 19: RELATED PARTY TRANSACTIONS In the fourth quarter of 2003, the Department of Transportation In November 1999, FedEx entered into a multi-year naming rights (“DOT”) asserted that we were overpaid by $31.6 million and has agreement with the National Football League Washington demanded repayment. We have filed requests for administrative Redskins professional football team. Under this agreement, FedEx and judicial review. We received an opinion from the District of has certain marketing rights, including the right to name the Columbia U.S. Court of Appeals stating that most of the determi- Redskins’ stadium “FedExField.” In August 2003, Frederick W. nations that we requested were not yet ripe for decision and the Smith, Chairman, President and Chief Executive Officer of FedEx, Court will not rule prior to final determination by the DOT and personally acquired an approximate 10% ownership interest in exhaustion of administrative remedies. the Washington Redskins and joined its board of directors. Pursuant to the Federal Aviation Administration reauthorization Mr. Smith’s son-in-law is a 50% owner of a company that provides enacted during the third quarter of 2004, the General Accounting insurance brokerage and consulting services in connection with Office submitted a report to Congress on June 4, 2004, on the cri- certain insurance and legal services plan benefits offered by teria and procedures used by the Secretary of Transportation FedEx to certain of its employees. Mr. Smith’s son-in-law’s com- under the Act. Issuance of the report frees the DOT to make pany is paid commissions and fees directly by the benefit a final determination on our claim and also reinforces the providers and not FedEx. During fiscal 2004, such commissions Congressional directive to the DOT to refer any remaining disputed and fees totaled approximately $497,000. claims to an administrative law judge upon an affected claimant’s A member of our Board of Directors, J.R. Hyde, III, and his wife request. together own approximately 13% of HOOPS, L.P. (“HOOPS”), the We agreed to mediation with the DOT, but it did not result in a res- owner of the NBA Memphis Grizzlies professional basketball olution of the dispute. We will continue to pursue our claim for team. Mr. Hyde, through one of his companies, also is the general compensation under the Act. partner of the minority limited partner of HOOPS. During 2002, FedEx entered into a multi-year, $90 million naming rights agree- We believe that we have complied with all aspects of the Act, ment with HOOPS that will be amortized to expense over the life that it is probable we will ultimately collect the remaining $18 mil- of the agreement. Under this agreement, FedEx has certain mar- lion receivable and that we will not be required to pay any portion keting rights, including the right to name the new arena where of the DOT’s $31.6 million demand. We cannot be assured of the the Grizzlies will play. Pursuant to a separate agreement with ultimate outcome; however, it is reasonably possible that a mate- HOOPS, the City of Memphis and Shelby County, FedEx has rial reduction to the $119 million of compensation we have agreed to pay $2.5 million a year for the balance of the 25-year previously recognized under the Act could occur. Based on the term of the agreement if HOOPS terminates its lease for the new DOT’s assertion, the range for potential loss on this matter is zero arena after 17 years. FedEx also purchased $2 million of municipal to $49.6 million. bonds issued by the Memphis and Shelby County Sports We are a defendant in a number of lawsuits filed in California Authority, the proceeds of which are to be used to finance a por- state courts containing various class-action allegations under tion of the construction costs of the new arena. California’s wage and hour laws. The plaintiffs in these lawsuits On March 26, 2004, FedEx purchased an aggregate of 94 acres of generally are hourly employees of FedEx operating companies real estate in Olive Branch, Mississippi, for $4.7 million. FedEx pro- who allege, among other things, that they were forced to work poses to construct a FedEx Ground hub on this site, which is just “off the clock” and were not provided work breaks. The plaintiffs south of Memphis. The 94-acre site is divided into three parcels, generally seek unspecified monetary damages, injunctive relief, two of which were owned by entities in which Mr. Hyde has a 50% or both. To date, only one of these cases has been certified as a ownership interest. These two parcels total approximately 3.4 class action. We believe that the claims in these cases are with- acres. An independent appraisal of the property determined its out merit. We have denied any liability with respect to these fair market value to be not less than the negotiated purchase price. claims and intend to vigorously defend ourselves in these cases.

74 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 20: SUMMARY OF QUARTERLY OPERATING RESULTS (UNAUDITED)

First Second Third Fourth (In millions, except per share amounts) Quarter Quarter Quarter Quarter

2004 (1) Revenues $5,687 $ 5,920 $6,062 $7,041 Operating income 200 (2) 183 (4) 372 685 Net income 128 (2)(3) 91(4) 207 412 (5) Basic earnings per common share (6) 0.43 (2)(3) 0.31(4) 0.69 1.38 (5) Diluted earnings per common share 0.42 (2)(3) 0.30 (4) 0.68 1.36 (5) 2003 Revenues $5,445 $ 5,667 $5,545 $5,830 Operating income 283 427 269 492 Net income 158 245 147 280 Basic earnings per common share (6) 0.53 0.82 0.49 0.94 Diluted earnings per common share 0.52 0.81 0.49 0.92

(1) Includes FedEx Kinko’s from February 12, 2004 (date of acquisition). See Note 2. (2) Includes $132 million ($82 million, net of tax, $0.28 per share, or $0.27 per diluted share) of business realignment costs described in Note 4. (3) Includes $26 million, net of tax ($0.09 per share or $0.08 per diluted share) related to a favorable ruling on an IRS case described in Note 11. (4) Includes $283 million ($175 million, net of tax, $0.59 per share, or $0.57 per diluted share) of business realignment costs described in Note 4. (5) Includes a $12 million ($0.04 per share and per diluted share) nonrecurring benefit related to the reduction of our effective tax rate. See Note 11. (6) The sum of the quarterly earnings per share may not equal annual amounts due to differences in the weighted-average number of shares outstanding during the respective periods.

75 FEDEX CORPORATION

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders FedEx Corporation We have audited the accompanying consolidated balance sheets of FedEx Corporation as of May 31, 2004 and 2003, and the related consolidated statements of income, changes in stockholders’ investment and comprehensive income, and cash flows for each of the three years in the period ended May 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of FedEx Corporation at May 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended May 31, 2004, in conformity with U.S. generally accepted accounting principles. As discussed in Note 3 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, in 2002.

Memphis, Tennessee June 22, 2004

76 FEDEX CORPORATION

SELECTED FINANCIAL DATA The following table sets forth certain selected consolidated financial and operating data for FedEx as of and for the five years ended May 31, 2004. This information should be read in conjunction with the Consolidated Financial Statements, Management’s Discussion and Analysis of Results of Operations and Financial Condition and other financial data appearing elsewhere herein.

(In millions, except per share amounts and other operating data) 2004 (1)(2)(3) 2003 2002 2001(4)(5) 2000 Operating Results Revenues $24,710 $ 22,487 $ 20,607 $19,629 $18,257 Operating income 1,440 1,471 1,321 1,071 1,221 Income before income taxes 1,319 1,338 1,160 927 1,138 Income before cumulative effect of change in accounting principle 838 830 725 584 688 Cumulative effect of change in accounting for goodwill (6) – – (15) – – Net income $ 838 $ 830 $ 710 $ 584 $ 688 Per Share Data Earnings per share: Basic: Income before cumulative effect of change in accounting principle $ 2.80 $ 2.79 $ 2.43 $ 2.02 $ 2.36 Cumulative effect of change in accounting for goodwill (6) – – (0.05) – – $ 2.80 $ 2.79 $ 2.38 $ 2.02 $ 2.36 Assuming dilution: Income before cumulative effect of change in accounting principle $ 2.76 $ 2.74 $ 2.39 $ 1.99 $ 2.32 Cumulative effect of change in accounting for goodwill (6) – – (0.05) – – $ 2.76 $ 2.74 $ 2.34 $ 1.99 $ 2.32 Average shares of common stock outstanding 299 298 298 289 292 Average common and common equivalent shares outstanding 304 303 303 293 296 Cash dividends declared $ 0.29 $ 0.15 $ 0.05 – – Financial Position Property and equipment, net $ 9,037 $ 8,700 $ 8,302 $ 8,100 $ 7,084 Total assets 19,134 15,385 13,812 13,392 11,527 Long-term debt, less current portion 2,837 1,709 1,800 1,900 1,776 Common stockholders’ investment 8,036 7,288 6,545 5,900 4,785 Other Operating Data FedEx Express aircraft fleet 645 643 647 640 663 Average full-time equivalent employees and contractors 195,838 190,918 184,953 176,960 163,324

(1) Results for 2004 include $435 million ($270 million, net of tax, or $0.89 per diluted share) of business realignment costs. See Note 4 to the accompanying audited financial statements. (2) Results for 2004 include the financial results of FedEx Kinko’s from February 12, 2004 (the date of acquisition). See Note 2 to the accompanying audited financial statements. (3) Results for 2004 include $37 million, net of tax, or $0.12 per diluted share benefit related to a favorable ruling on an aircraft engine maintenance tax case and the reduction of our effective tax rate. See Note 11 to the accompanying audited financial statements. (4) Results for 2001 include the financial results of FedEx Freight East from January 1, 2001 (the date of acquisition for financial reporting purposes). (5) Asset impairment charges of $102 million ($65 million, net of tax, or $0.22 per diluted share) at FedEx Express and reorganization costs of $22 million ($14 million, net of tax, or $0.05 per diluted share) at FedEx Supply Chain Services were recorded in 2001. (6) Results for 2002 reflect our adoption of SFAS 142, “Goodwill and Other Intangible Assets.” We recognized an adjustment of $25 million ($15 million, net of tax, or $0.05 per share) to reduce the carrying value of certain goodwill to its implied fair value. See Note 3 to the accompanying audited financial statements.

77 FEDEX CORPORATION

BOARD OF DIRECTORS

James L. Barksdale(2)(3) J.R. Hyde, III(3) Chairman and President Chairman Barksdale Management Corporation GTx, Inc. Investment management company Biopharmaceutical company

August A. Busch IV(2) Dr. Shirley A. Jackson(3)(4) President President Anheuser-Busch, Inc. Rensselaer Polytechnic Institute Brewing organization Technological university

John A. Edwardson(1*) George J. Mitchell(2)(4) Chairman and Chief Executive Officer Partner CDW Corporation Piper Rudnick LLP Technology products and services company Law firm

Judith L. Estrin(3*) Frederick W. Smith President and Chief Executive Officer Chairman, President and Packet Design, LLC Chief Executive Officer Internet technology company FedEx Corporation

J. Kenneth Glass(1) Dr. Joshua I. Smith(1) Chairman, President and Chairman and Managing Partner Chief Executive Officer Coaching Group, LLC First Horizon National Corporation Consulting firm Bank holding company Paul S. Walsh(2) Philip Greer(2*) Chief Executive Officer Managing Director Diageo plc Greer Family Consulting & Investments, LLC Consumer food and beverage company Investment management firm Peter S. Willmott(1)(4*) Chairman and Chief Executive Officer Willmott Services, Inc. Retail and consulting firm

(1)Audit Committee (2)Compensation Committee (3)Information Technology Oversight Committee (4)Nominating & Governance Committee * Committee Chair

78 FEDEX CORPORATION

EXECUTIVE OFFICERS AND SENIOR MANAGEMENT

FedEx Corporation Kenneth R. Masterson Frederick W. Smith Executive Vice President, General Counsel and Secretary Chairman, President and Chief Executive Officer T. Michael Glenn Alan B. Graf, Jr. Executive Vice President, Executive Vice President and Chief Financial Officer Market Development and Corporate Communications

Robert B. Carter John L. Merino Executive Vice President and Chief Information Officer Corporate Vice President and Principal Accounting Officer

FedEx Express FedEx Ground David J. Bronczek Daniel J. Sullivan President and Chief Executive Officer President and Chief Executive Officer

David F. Rebholz Rodger G. Marticke Executive Vice President, Executive Vice President and Chief Operating Officer Operations and Systems Support Bram B. Johnson Michael L. Ducker Executive Vice President, Executive Vice President, International Strategic Planning, Quality Management and Communications

FedEx Freight FedEx Kinko’s Douglas G. Duncan Gary M. Kusin President and Chief Executive Officer President and Chief Executive Officer

Patrick L. Reed Kenneth A. May President and Chief Executive Officer, FedEx Freight East Executive Vice President and Chief Operating Officer

Keith E. Lovetro Paul G. Rostron President and Chief Executive Officer, FedEx Freight West Executive Vice President and Chief People Officer

FedEx Custom Critical FedEx Trade Networks John G. Pickard G. Edmond Clark President and Chief Executive Officer President and Chief Executive Officer

FedEx Supply Chain Services Caribbean Transportation Services Douglas E. Witt Rick A. Faieta President and Chief Executive Officer President and Chief Executive Officer

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CORPORATE INFORMATION CONTACT INFORMATION Corporate Headquarters: 942 South Shady Grove Road, Customer Inquiries: Call l-800-Go-FedEx or visit the Memphis, Tennessee 38120, (901) 818-7500. Customer Support section of fedex.com: http://www.fedex.com/us/customersupport/ Annual Meeting: The annual meeting of shareowners will be held in the Tennessee Grand Ballroom at the Hilton Hotel, General and Media Inquiries: Contact FedEx Public Relations, 939 Ridge Lake Boulevard, Memphis, Tennessee 38120, 942 South Shady Grove Road, Memphis, Tennessee 38120, on Monday, September 27, 2004, at 10:00 a.m. Central time. (901) 434-8400 or the About FedEx section of fedex.com: http://www.fedex.com/us/about/ FINANCIAL INFORMATION Shareowner Account Inquiries: Contact EquiServe Trust Stock Listing: FedEx Corporation’s common stock is listed on Company, N.A., P.O. Box 43069, Providence, Rhode Island the New York Stock Exchange under the ticker symbol FDX. 02940-3069, (800) 446-2617. Shareowners: As of July 12, 2004, there were 17,901 shareown- Direct Stock Purchase and Dividend Reinvestment Inquiries: ers of record. For information on the direct stock purchase and dividend reinvestment plan for FedEx Corporation common stock, call Market Information: Following are high and low sale prices and EquiServe at (800) 446-2617 or visit their direct stock purchase cash dividends paid, by quarter, for FedEx Corporation’s common plan Web site at equiserve.com. This plan provides an alterna- stock in 2004 and 2003. tive to traditional retail brokerage methods of purchasing, First Quarter Second Quarter Third Quarter Fourth Quarter holding and selling FedEx common stock. This plan also permits FY 2004 shareowners to automatically reinvest their dividends to pur- High $68.96 $78.05 $75.15 $76.07 chase additional shares of FedEx common stock. Low 59.01 63.70 64.84 65.88 Dividend 0.05 0.05 0.06 0.06 Investor Inquiries: Contact J.H. Clippard, Jr., Vice President, Investor Relations, FedEx Corporation, 942 South Shady Grove FY 2003 Road, Memphis, Tennessee 38120, (901) 818-7200, e-mail High $57.25 $56.24 $58.60 $64.35 [email protected] or visit the Investor Relations section of Low 43.71 42.75 47.70 48.18 fedex.com: http://www.fedex.com/us/investorrelations/ Dividend 0.05 0.05 0.05 0.05 GENERAL INFORMATION FedEx paid its first cash dividend on July 8, 2002 and Dividends: Equal Employment Opportunity: Our greatest asset is our has paid a cash dividend each subsequent quarter, including on people. We are committed to providing a workplace where July 1, 2004 ($0.07 per share). We expect to continue to pay our employees and contractors feel respected, satisfied and regular quarterly cash dividends, though each quarterly dividend appreciated. Our policies are designed to promote fairness is subject to review and approval by our Board of Directors. and respect for everyone. We hire, evaluate and promote Financial Information: Copies of FedEx Corporation’s Annual employees, and engage contractors, based on their skills and Report on Form 10-K, other documents filed with the Securities performance. With this in mind, we will not tolerate certain and Exchange Commission (SEC) and other financial and statisti- behaviors. These include harassment, violence, intimidation cal information are available through our Web site at fedex.com. and discrimination of any kind involving race, color, religion, The most recent certifications by our principal executive and national origin, gender, sexual orientation, age, disability or, financial officers pursuant to Section 302 of the Sarbanes- where applicable, veteran or marital status. Oxley Act of 2002 are filed as exhibits to our Form 10-K. You will Service Marks: The following are registered service marks of be mailed a copy of the Form 10-K upon request to Investor Federal Express Corporation, registered with the U.S. Patent & Relations, FedEx Corporation, 942 South Shady Grove Road, Trademark Office and in other countries: FedEx®,FedEx Express®, Memphis, Tennessee 38120, (901) 818-7200, e-mail [email protected]. FedEx Ground®, FedEx Freight®, FedEx Custom Critical®, FedEx Company documents filed electronically with the SEC can also Supply Chain Services®, FedEx InSight®, FedEx Home Delivery ® be found at the SEC’s Web site at www.sec.gov. and FedEx International Priority DirectDistribution®. The Independent Registered Public Accounting Firm: following are service marks of Federal Express Corporation: Ernst and Young LLP, Memphis, Tennessee. FedEx Trade NetworksSM, FedEx ServicesSM and Caribbean Transportation ServicesSM. DocStore® is a registered service mark of Kinko’s Ventures, Inc. FedEx Kinko’s Office and Print CentersSM is a service mark of Federal Express Corporation and Kinko’s Ventures, Inc. Design: EAI/Atlanta Printing: Lithographix, Inc. Photography: Christopher Wahl This entire annual report is printed on recycled paper.

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